Originally published by Peak 1031 Exchange (peakexchange.com)
If you’re planning to sell a business that owns real estate, you might be able to take advantage of a 1031 exchange to defer capital gains taxes on the sale of the real estate portion. While business assets themselves are not eligible for a 1031 exchange, the real estate can qualify, allowing you to reinvest in other like-kind real property without immediate tax liability.
Here’s what you need to know about selling a business with real estate and how to structure a 1031 exchange.
Separate Real Estate from Business Assets
The first thing to understand is that only real estate qualifies for a 1031 exchange. Personal property, such as business inventory, equipment, and goodwill, does not qualify. This means when selling a business that owns real estate, you’ll need to allocate separate dollar values to the real estate and the other business assets.
In the contract of sale, it’s crucial to itemize the real estate as a distinct asset from the business operations. Separate dollar values should be assigned to the real estate versus the personal property, equipment, and other business assets. Proper allocation helps to ensure that the real property portion of the sale is tax-deferred via the 1031 exchange, and also aids in determining the requisite replacement property value for that exchange.
Real Property Must Be for Investment Purposes
In order for the real estate to qualify for a 1031 exchange, it must be held for investment or business use. Personal-use properties do not qualify. This means that if the business owns property used for commercial purposes—such as an office building, retail space, or industrial property—it may be eligible for an exchange.
Similarly, the replacement property you acquire in the exchange must also be held for investment or business purposes. This could include another commercial building, rental property, or vacant land intended for future investment.
Allocating Value Between Real Estate and Business Assets
When selling a business, the sale price typically includes both the real estate and other business assets. However, proper allocation of value between these components is critical for both tax reporting and ensuring the 1031 exchange is applied correctly.
To avoid complications and ensure compliance, it’s essential to work with a CPA or tax advisor to help you allocate the sale price between the real property and the non-real estate assets. This process often involves determining the fair market value of both the real estate and the personal property being sold. A tax professional can guide you on the most tax-efficient way to structure this allocation, especially since different tax treatments may apply to various components of the sale (e.g., capital gains on the real estate versus ordinary income on business assets).
Partnerships and Entity Structures
If the business is owned as part of a partnership (like an LLC or LP), special considerations apply. All partners must generally agree to the 1031 exchange. If one partner wants to cash out while others want to pursue the exchange, this can complicate the process. However, there are potential solutions to this problem. See our article on Partnership Issues in 1031 Exchanges for a more in-depth discussion.
Tax Implications of Selling a Business with Real Estate
While the 1031 exchange allows deferral of taxes on the real estate portion of the sale, other business assets like machinery, equipment, and goodwill are subject to capital gains or ordinary income taxes. These will be reported separately from the real estate transaction.
Given the complexity of selling a business that owns real estate, it’s essential to consult both a qualified intermediary (to facilitate the 1031 exchange) and your tax professional to ensure the transaction is structured for optimal tax benefits.
Conclusion
Selling a business with real estate presents a valuable opportunity to use a 1031 exchange to defer taxes on the real estate portion of the sale. By separating the real estate from other business assets, properly allocating values, and consulting with your tax advisor, you can navigate the transaction successfully while maximizing your tax deferral benefits.
As always discuss your options with your attorney or tax advisor.
