Creating Your Business Metropolis

How business owners can utilize a §1031 exchange

A business owner’s proverbial journey to Ithaca often begins at home. Tucked away next to a kitchen, the entrepreneur creates the enterprise in a small office. Toiling for a period, the odyssey continues, and he eventually purchases a small facility as business prospers. Operations continue at this facility until the entrepreneur develops grandeurs of conquest and greater glories. He spies a larger complex that will fulfill his desires of expanding his empire. Alas, there is only one problem—the fear of taxes in the form of capital gains! In answering the Sphinx’s riddle, §1031 will assist the owner in achieving greater spoils of victory.

A §1031 exchange is a prudent tax and investment strategy that allows the budding entrepreneur to upgrade his facility from hamlet to metropolis without the consequences of capital gains. Since real estate transaction opportunities frequently arise, owners of small- to mid-size businesses are especially good candidates to take advantage of the §1031 exchange. In theory, a small business owner could defer capital gains on investment property until death, potentially avoiding taxes completely.

The crucible of §1031 is that when the property owner reinvests the sale proceeds into another parcel, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g., vacant land exchanged for an apartment building). If §1031 is not utilized, the investment serves as a Trojan horse by acting as a vehicle for the hostile invasion of immediate capital gains.

To qualify as a §1031 transaction, it must take the form of an “exchange” rather than just a sale of one property with the subsequent purchase of another. First, the property being sold and the new replacement property must both be held for investment purposes or for productive use in a trade or a business.

Examples of property held for investment include:

  • Rental real estate (e.g., an apartment building)
  • Real estate (even vacant and unproductive land) held with the expectation of appreciation

Examples of property held for productive use in a trade or business include:

  • Real estate owned by a corporation and used as a manufacturing facility
  • Business equipment (e.g., an excavator)
  • Vehicles used for business purposes

Property held for productive use in a trade or business may be exchanged for property held for investment. Conversely, property held for investment may also be exchanged for property held for productive use in a trade or business. Section 1031 does not specifically apply to exchanges of stock, bonds, notes, partnership interests or inventory. Moreover, it does not apply to property held with the intent to resell. Therefore, real estate held by an individual for investment purposes may qualify as a §1031 exchange, but real estate acquired by a developer will not qualify as a §1031 exchange because the property was acquired with the intent to resell. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

Before the entrepreneur launches his fleet for conquest, he must still answer the siren’s call of “timing requirements.” The battlefield is littered with bodies who failed to comply with the code and regulations regarding strict requirements for the timing of a §1031 exchange. These requirements concern the (1) identification of the replacement properties, and (2) the acquisition period.

45-day identification period
In order to navigate through the murky shoals of the code, the “replacement” property must be identified by the seller on or before the 45th day following the transfer of the relinquished property. Identification of all replacement property must be made in writing and must be signed by the seller. The seller may identify as many as three properties, regardless of their total value (known as the three-property rule), or the seller may identify any number of properties provided their aggregate fair market value on the 45th day does not exceed 200 percent of the aggregate fair market value of all the relinquished property on the date of its transfer (known as the 200-percent rule).

180-day acquisition period Generally, a party has 180 days to complete a like-kind exchange transaction. The 180-day completion rule is limited to the due date of the tax return for the year in which the transfer was made. The tax return due date, however, may include extensions.

After the ships have docked and victory of deferring capital gains is within sight, the mere exchange of property may be difficult. Section 1031 contains provisions allowing a seller to transfer the “relinquished” property to a qualified intermediary (QI), who will then facilitate the sale of the “relinquished” property and the purchase of the “replacement” property. As part of the transaction, the QI sells the property and holds the proceeds in escrow until the “replacement” property has been identified and the transaction is ready to close. Without the use of a QI, the sale of the “relinquished” property would be subject to tax if the seller received, or could have received, the proceeds from the sale transaction.

Trying to benefit from the tax breaks in the Internal Revenue Code is often a journey through a Byzantine labyrinth. However, with divine intervention from an experienced “oracle”—or a tax professional— business owners can take advantage of tax strategies such as the §1031 like-kind exchange to conquer the Minotaur of capital gains. This effective tax strategy, in addition to many others, should not be overlooked or deemed as an underutilized artifact by the savvy and intrepid tax archeologist.