Federal and state capital gain and depreciation recapture taxes can be deferred in a 1031 exchange when selling a business and replacing with like-kind fixtures and equipment. Otherwise, federal and state capital gain and depreciation taxes will represent upwards of 40 percent of the sales price. If the intent is to replace with like-kind property, then consider a 1031 exchange.
Business Sale
When a business is sold, such as a restaurant, the sale is composed of real and personal property, good will and possibly a non-compete clause, while the business assets are segregated into different asset groups, such as furniture, fixtures, cooking equipment and perhaps franchise rights or licenses. Good will and non-compete clauses are not eligible for a 1031 exchange. Many times the business leases the real property. If the lease is for greater than thirty years, the lease is eligible for a 1031 exchange. If not, personal property, both tangible and intangible, is the typical asset engaged in a 1031 exchange.
A personal property exchange only makes sense when the general asset class or North American Industry Classification System associated with the relinquished or old property matches the replacement property. If not, then the 1031 exchange does not work.
When selling a business, a dentist, veterinarian or optometrist interested in a 1031 exchange should visit their CPA to understand the tax consequences. Is there adequate depreciation recapture to warrant a 1031 exchange? If personal property is being sold, is the Taxpayer’s intent to replace with like-kind replacement property? Once these two questions are answered, the Taxpayer is in the position to determine whether or not to initiate a 1031 exchange. There are many rules to follow in a 1031 exchange. If the 1031 exchange rules are not followed and if ever audited, the IRS will surely overturn the 1031 exchange. An overturned 1031 exchange results in the tax being due, along with a possible penalty and interest due on the tax not paid.
Can leasehold improvements be exchanged? It depends. How does the lease handle leasehold improvements? Many times, leasehold improvements paid by the lessee are the property of and owned by the lessor. If the Taxpayer or lessee owns the leasehold improvements, then they can be exchanged for newly constructed tenant improvements in the replacement property.
Next, the Taxpayer should engage a Certified Exchange Specialist® to provide the Qualified Intermediary (QI) accommodation services for the 1031 exchange and discuss the transaction. The QI will ask questions and help the Taxpayer understand how a 1031 exchange applies to their sale and walk through the steps of the exchange.
If your business is located in Washington, Oregon, California, Nevada, Idaho, Colorado, Virginia or Maine, there are state mandated regulations the QI must follow or be subject to civil or criminal penalties. To protect your exchange funds, be sure to engage a QI that complies with these state laws. Each state requirement can be found by viewing the following page and selecting the state in the lower right hand corner.
A series of QI vetting questions are available for download by clicking on the button below. These are the questions experienced investors ask to understand the QI’s knowledge and experience to avoid engaging an accommodating accommodator.
