Business owners spend years building a successful business that provides a steady stream of income. As owners age and begin to ponder retirement, they often consider the sale of their business either to a descendent, a key employee or a third party. Many worry whether they will be able to accomplish their retirement objectives (second home, extensive travel, maintain current quality of life, etc.) with their savings and the proceeds of the sale of the business. With a 1031 exchange, some of those assets will continue to generate a profit for the owner, even years after the sale.
As we have discussed many times, almost ANY asset held for business use or investment will qualify for tax-deferral treatment under Section 1031. This includes the real estate, equipment, patents, etc. While many of the tangible and intangible assets of the business could be exchanged, the business owner will likely not want to acquire “like-kind” assets. However, the real estate assets are a different story as they can be exchanged for ANY real estate to be held for business use or investment. This provides an endless number of opportunities.
A few strategies are discussed below:
- Replace Income Stream Lost with Sale of Business: There are many ways to accomplish this with the level of property management one wants. More hands on properties would include single family rentals, small apartment buildings and single tenant commercial properties. For larger investments such as multi-family, office buildings and industrial properties, a property manager might be helpful. A Triple Net Lease (NNN) property, such as CVS, Walgreen, chain restaurant, etc., is a more passive investment where an investor owns the land and improvements but the tenant typically pays the property taxes, insurance, maintenance, repairs and utilities.
- Acquire Future Second Home: While the 1031 exchange proceeds cannot be use to acquire a vacation home, they can be used to acquire a property that will be used as a rental and eventually converted into a second home or primary residence. The property can be managed by you or a leasing agent. It should be treated as a rental property for at least the first few years although you or your family can use it for the greater of 14 days or 10% the number of days rented annually. This strategy lets one acquire the property in the area they want to retire or establish a second residency – perhaps in a resort area or near their grandchildren.
As a bonus, when he eventually sells his current primary residence, assuming he has lived in it for at least 24 or the last 60 months, under section 121, he will qualify for a $250,000 ($500,000, if married filing jointly) exclusion. An exclusion means the first $250,000 (or $500,000) of gain is exempt from tax.
The greatest benefit of Section 1031 is the flexibility is affords. The business owner can work with his tax advisors to put together a plan that will help him accomplish his objectives. It also allows the flexibility to diversify the types of property or geographic location of them. Be sure to consider Section 1031 when you are planning your exit strategy.
