It is no secret that real estate investors utilize Section 1031 to help grow their real estate portfolio with pre-tax dollars, but 1031 exchanges are just as beneficial for business owners. They allow businesses to move into more efficient properties while keeping more cash in their business, enabling the business to grow faster and have more employees with less leverage.
Benefits for Business Owners
When exchanging, in addition to deferring the capital gains, you also defer the depreciation recapture. For business owners who took bonus depreciation in recent years, this is especially beneficial and helps keep valuable capital invested in the business.
Following are a few examples of how 1031 exchanges can help:
- Expand business into multiple locations.
- Structure a sale-lease back to free up capital and use exchange funds to acquire or lease a second and maybe more locations. Note a leasehold interest of 30 years or more, including options, qualify as real property. Exchange funds can be used to prepay rent and/or fit out the space through an improvement exchange.
- Relocate to a better facility (more desirable location, more efficient building, additional space, increased parking, etc.).
- Couple with tax incentives sometimes offered by counties or cities.
- Partner with SBA or redevelopment authority to obtain favorable financing opportunities.
- Refinance the replacement property to free up cash to be used for any purpose.
A 1031 exchange can also provide a business owner an exit strategy when selling a business that includes real estate. The real estate can be exchanged and open a number of new opportunities:
- Purchase replacement that will generate steady cash flow.
- Acquire property with passive income, such as a Triple Net Lease (NNN) property, Delaware Statutory Trust (DST), or oil and gas royalties.
- Purchase a rental property in the area the business owner wants to retire and rent for two years before converting the property to a personal use home. There is no tax liability due at the time the character of the property changes.
Some of the requirements of a successful exchange are as follows:
- In a 1031 tax-deferred exchange, you must acquire like-kind property but any kind of real property can be exchanged for any other kind of real property. Like-kind refers to the nature or character of the property, not the specific type of property. What makes real property like-kind to another is that they are held for productive use in a trade or business or for investment.
- A Qualified Intermediary (QI), such as 1031 CORP., is required to facilitate the exchange.
- The Exchanger must not have actual or constructive receipt of the sale proceeds, including deposit monies.
- Once the relinquished property is conveyed to a buyer, the Exchanger has two important deadlines that run concurrently:
- 45-Day Identification Period to identify replacement property or properties; and
- 180-Day Exchange Period to acquire all desired identified replacement property.
- To maximize the tax-deferral, replacement property of equal or greater value and equity must be acquired. In the event of a trade down in value or equity, the Exchanger is taxed on the amount of the trade down.
- Any taxpayer, whether an individual or an entity, can complete a 1031 exchange but title to the replacement property must be held by the same taxpayer as the relinquished property.
- The basis and depreciation schedule of the relinquished property carries over to the replacement property. Both are increased by any increase in property value acquired.
- The 1031 exchange must be set up prior to the transfer of the relinquished property to a buyer.
By deferring the taxes, business owners can adjust their real estate holdings to changing situations and business needs without being tax-locked into yesterday’s inefficiencies. Removing the tax lock-in effect promotes the highest and best use of properties. Because they can defer the taxes, 1031 investors invest 30% more into their properties than other investors. All of this results in improved communities and affordable neighborhoods. The 1031 exchange must be set up prior to the transfer of the relinquished property to a buyer.
