What is a Section 1031 Exchange?
A taxpayer may defer capital gains taxes on the sale of certain investments or business assets by swapping like-minded properties. This is called a section 1031 exchange. Under a 1031 exchange, capital gains taxes may be deferred so long as the asset being sold and the asset being swapped qualifies for the exchange, a qualified intermediary is informed of the replacement property in writing within 45 days of the original sale, and the closing takes place (on the swapped property) within 180 days of the original sale. The same taxpayer may use section 1031 Exchanges an unlimited amount of time and may in theory defer capital gains taxes indefinitely.
Section 1031 Exchanges Have Limited Role
- No seller desires to pay taxes after selling their business.
- Long term capital gains taxes can be as high as 20 percent of the purchase price (and may increase!).
- Unfortunately, Section 1031 Exchanges have limited application to most business sales.
- This is because the favorable tax treatment afforded by Section 1031 only applies to the sale of certain assets such as real estate property used by the business, corporately owned personal property (such as company owned vehicles, heavy machinery, or restaurant equipment), and ‘lines of business’ such as franchise or territory rights.
- Specifically, Section 1031 Exchanges do not cover the sale of goodwill, which is typically the major component of the business sale.
- Goodwill is the portion of the purchase price that represents the premium above and beyond its net tangible value.
- The goodwill can be referred to as the intangible assets of a business.
Real Estate Attached to Business Qualifies
For business owners that own the commercial property housing their business, such property may be sheltered from capital gains taxes if properly exchanged under Section 1031. The sales price of the commercial property must be separated from the sales price of the business in order to determine what qualifies for a section 1031 Exchange.
- Let’s say for example that an auto shop owner owns the building that houses his or her auto repair shop.
- Then let’s say the auto shop owner is able to sell the business for $200,000 and the building for $300,000.
- The proceeds from the sale of the building ($300,000) may qualify to be sheltered under Section 1031.
- The sale of the business (to the extent that the sale reflects the goodwill of the business) may not qualify to be sheltered, and capital gains taxes would apply.
- In order for the sale of the building to qualify for a section 1031 Exchange, the seller must assign their rights to the proceeds for the building to a qualified intermediary (with help from their attorney) who receives the cash from the sale of the building.
- Then the seller has 45 days after the sale to inform the qualified intermediary in writing of another commercial property (which would be a like-minded property) that the seller desires to purchase.
- The seller has 180 days to close on the replacement commercial property from the date of the original sale.
Corporate Personal Property May Qualify
Certain physical assets (or hard assets) such as equipment, machinery, and vehicles may be separately identified and segregated from the sale for the goodwill of the business. This corporate personal property (as defined under Section 1031) may qualify for a Section 1031 Exchange. The goodwill of the business being sold does not qualify. Importantly, inventory is not included as a physical asset that would qualify for a section 1031 Exchange. The seller must purchase a ‘like-minded’ physical asset in order to properly effectuate the Exchange and defer capital gains taxes from the sale of the corporate personal property. Expert accounting and attorney advice in such instances is strongly recommended.
A ‘Line of Business’ Exchange Qualifies Under Section 1031
- Selling a ‘line of business’ qualifies under Section 1031 and would shelter proceeds from capital gains taxes so long as the seller purchases another like-minded ‘line of business’ within 180 days of the sale.
- A ‘line of business’ under Section 1031 is limited to franchise rights or broadcast rights (items with discrete and calculable value that give the business a right to engage the public).
- Note that goodwill by itself does not qualify under a Section 1031 Exchange.
- But the goodwill of a business may be included as a component of the franchise rights of a business when calculating what qualifies under Section 1031.
Disadvantages of Using Section 1031 Exchange
Deferring capital gains taxes is the obvious advantage of using Section 1031 Exchanges, and can be a great tool to defer taxes. But business owners should be aware that there are risks and costs with using the Exchange. For business owners needing the infusion of cash associated with closing a business deal, then Section 1031 Exchanges may not work for them. That is because the qualified intermediary receives the cash at closing pending the purchase of the replacement property. Also, attorneys and accountants do not come cheap these days! So while sellers should always be in control of the deal, high transaction costs are unavoidable when structuring and executing a Section 1031 Exchange. It is quite possible that the seller may not be able to find a suitable replacement property within 45 days of the original sale, at which point the transaction costs would be wasted and the capital gains tax on the original sale would be owed.
It may take many months to properly locate replacement property and conduct proper due diligence in order to find a replacement asset under a 1031 Exchange. Business owners should start identifying like-minded replacement property well before the sale of their business. Overall, a 1031 Exchange is an excellent way in which a business seller may defer some capital gains taxes.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.