44.10 Should You Trade in Business Equipment?

The purchase of new business equipment is often partially financed by trading in old equipment. For tax purposes, a trade-in may not be a good decision. If the market value of the equipment is below its adjusted basis, it may be preferable to sell the equipment to realize an immediate deductible loss. You may not deduct a loss on a trade-in. However, if you do trade, the potential deduction reflected in the cost basis of the old equipment is not forfeited. The undepreciated basis of the old property becomes part of the basis of the new property and may be depreciated. Therefore, in deciding whether to trade or sell where a loss may be realized, determine whether you will get a greater tax reduction by taking an immediate loss on a sale or by claiming larger depreciation deductions.

If the fair market value of the old equipment exceeds its adjusted basis, you have a potential gain. To defer tax on this gain, you may want to trade the equipment in for new equipment. Your decision to sell or trade will generally be based on a comparison between (1) tax imposed on an immediate sale and larger depreciation deductions taken on the cost basis of the new property, and (2) the tax consequences of a trade-in in which the tax is deferred but reduced depreciation deductions are taken on a lower cost basis of the property. In making this comparison, you will have to estimate your future income and tax rates. Also pay attention to the possibility that gain on a sale may be taxed as ordinary income under the depreciation recapture rules (44.1).

The tax consequences of a trade-in may not be avoided by first selling the used property to the dealer who sells you the new property. The IRS will disregard the sale made to the same dealer from whom you purchase the new equipment. The two transactions will be treated as one trade-in.