Leveraging a 1031 Exchange for Business Owners with Real Estate Holdings
By Melissa Pedigo
If you're a business owner who also owns the real estate associated with your business, you might be wondering if you can use a 1031 exchange to your advantage. The answer is, "Yes, you can."
One benefit of a 1031 exchange is that you will not need to pay a dime in capital gains tax immediately after you sell your property.
And as you may want to know, this can be quite a game-changer for real estate investors, business owners, and taxpayers in general, especially if you don’t want to see a big dent in your cash flow.
But what exactly is a 1031 exchange, and how can you take advantage of it?
We’ll help you understand:
- What a 1031 exchange is
- The type of properties that qualify for a 1031 exchange
- How to take advantage of a 1031 exchange as a tax strategy
What Is a 1031 Exchange?
The essence of a 1031 exchange (also called a like-kind exchange) is this: it takes place when you swap one property for another in a specific manner that allows you to defer paying capital gains tax that would have been due immediately.
If you’ve never heard of this tax-friendly transaction, you’re late to the party. The tax code has allowed tax-deferring property swaps for almost a hundred years. However, the provisions have been fine-tuned to define the types of property that qualify for tax deferral in these types of exchange.
Today, particularly with the Tax Cuts and Jobs Act of 2017, a tax-deferred 1031 exchange comes with a crucial rider. According to the current 1031 exchange rules, a qualifying property must be real property held for trade, business, or investment purposes.
What Qualifies as Real Property in a 1031 Exchange?
According to the IRS final regulations in November 2020, tax deferral on capital gains only applies when you swap real property. The IRS defines real property as land, and anything permanently built on or attached to it.
But not all real property swaps qualify as 1031 exchanges. According to the tax code, real property must be held for productive use in a trade or business or as an investment property.
So, no, you cannot exchange your primary residence for another because your home is personal property. But if you swapped a rental property for another rental property, you could do a 1031 exchange.
The real property that qualifies for a 1031 exchange must be of the same like and kind.
What Is a Like-Kind Property?
Like-kind property means you cannot exchange property used in trade or business for another that’s personal.
In essence, a like-kind property is a property that is like another (but not necessarily identical) in terms of usage and purpose.
So you can exchange a piece of land in Arlington, Texas, for an apartment building in Manhattan as long as both are used in a trade or business or for investment. It doesn’t have to be raw land for raw land or commercial real estate for commercial real estate.
But another critical factor to keep in mind is timing. You must follow crucial deadlines and rules to successfully complete a 1031 exchange.
1031 Exchange Timelines
For 1031 exchanges, the following two-timing rules apply.
- 45-day Rule
- 180-day Rule
What Is the 45-day Rule?
According to the 45-day rule, if you sell your property, you must identify potential replacement property within 45 days.
What Is the 180-day Rule?
According to the 180-day rule, you must close the purchase of your replacement property within 180 days of selling the old property.
Note: You must use a qualified intermediary with a 1031 exchange to hold the sale proceeds and use them to purchase the new property. You won’t qualify for a 1031 exchange if you receive the sales proceeds directly.
What Are the Tax Advantages and Strategies of a 1031 Exchange?
The primary tax advantage of a 1031 exchange is you avoid immediately paying capital gains tax on the sale of your property.
Be sure your replacement property is equal to or of greater value than the selling price of your relinquished property. If you receive cash back because you bought cheaper property, you generally will pay tax on the cash amount.
Also, most states allow deferral of state taxes when you complete a 1031 exchange. And you’ll also defer recognizing your depreciation recapture.
And sometimes, you may acquire more than one replacement property. Consult an attorney or a CPA if you’re considering a 1031 exchange.
Do You Want to Take Advantage of a 1031 Exchange?
When selling real property, what matters is not the amount of money you’ll make, but the amount of money you’ll keep. This is often because of capital gains tax.
With a 1031 exchange, however, you won’t need to worry about capital gains tax.
If you're selling your business and own the real estate related to it, it's important to know the options you have for your commercial property. To sell a business that includes real estate holdings, it is crucial to have a team of advisors to help navigate the multi-step process. Visit the BizBuySell Broker Directory to find a business broker who can advise you throughout the process.
By Melissa Pedigo