1031 Exchange on a Business Sale
Every business or franchise owner should plan ahead for a time when the decision is made to sell. This planning is critical when the owner desires to continue in another business or franchise in a different location. A failure to consider and plan for the tax saving benefits of a 1031 exchange before closing on the sale can leave the business owner with far less capital after taxes to reinvest in another business such as in a dental office sale or a gas station sale as examples..
However, by working with a Qualified Intermediary (Adelphi Retirement Management, LLC.) in advance and identifying the business assets that would qualify for tax deferral in a 1031 exchange, business and franchise owners can often reduce their current tax liability and retain more funds to be reinvested in another business or franchise. Internal Revenue Code Section 1031 allows business owners to exchange “like kind” real and personal property for other “like kind” real or personal property. While real property has a very broad application of “like kind”, personal property does not. Section 1031 generally requires that personal property be exchanged for other personal property that is “like kind” or “like class.” Depreciation personal property is considered “like kind” if it is within the same Product Class or General Asset Class. Product and General Asset Classes are described in a North American Industry Classification System (NAICS). Personal property can be exchange for other property of “like kind” in some cases, even if it is not in the same Product or General Asset Class.
WHAT CAN BE EXCHANGE UNDER §1031 EXCHANGE?
- Depreciable tangible personal property used in the trade or business
- Franchise agreement/rights
- Equipment and furnishings
- Leasehold improvements*
- Customer lists
- Real property
WHAT IS NOT EXCHANGEABLE UNDER 1031 EXCHANGE?
- Goodwill
- Covenants not to compete
- Inventory
- Securities, stocks, bonds or evidence of indebtedness
There are also many business transactions that involve the sale of both real property and personal property, such as the sale of hotels, restaurants, convenience stores and gas stations, where business owners possesses both real and personal property.
In those cases, the business owner must generally allocate the consideration received for the personal property assets relinquished in the exchange among the Product Classes or General Asset Classes. The amount so allocated by class will be used to determine how much replacement property of each class must be obtained in the exchange to achieve full tax deferral. With the sale if a business or franchise, it is essential that the business owner work with a tax advisor well in advance to identify exchangeable assets and to strategize on the optimal allocation of the sale price given the business owner’s future plans. Even with planning, a business owner may not be able to match up all the allocations with like-kind replacement property, so some taxable boot is common. Notwithstanding some boot, the benefits of tax deferral can be enormous.
EXCHANGEABLE ASSETS
The first and most important step when exchanging a farm or ranch is to itemize the various assets and determine which of those assets are exchangeable. Real property and many types of personal property can be exchanged under Internal Revenue Code §1031; however, real property can only be exchanged for like kind real property, and personal property for like kind personal property. In addition, certain assets such as goodwill and inventory are not exchangeable.
EXCHANGEABLE REAL PROPERTY ASSETS
Real property: The real estate assets of a farm or ranch include the land and any improvements attached to the land such as a house or a barn. If the house on the farm is occupied by a tenant, worker or caretaker on the property, it is considered investment property or property used in a trade or business and is exchangeable under §1031. On the other hand, if the owner lives in this house on the property and it is consider the owner’s primary residence, there are advantageous tax strategies that can be implemented in conjunction with the 1031 exchange. When a property is held partially for personal use and partially for investment, such as a working farm or ranch with an owner occupied home, a portion of the gain from the sale of the personal residence is exempt from tax under Section 121 (sale of primary residence) and the remaining tax can be deferred under §1031. Revenue Procedure 20015-14 clarifies how Section 121 and 1031 can be used at the same time in connection with the deposition of the same property.
Crops: Harvested crops are considered inventory and are not exchangeable under §1031. It is possible to exchange unharvested crops when they are sold with land, at the same time and to the same person, provided that the land was held by the owner for investment purposes for more than 1 year and 1 day. In addition, in order to trade the unharvested crops for real estate, the unharvested crops must be considered to be real estate under state law.
EXCHANGING PERSONAL PROPERTY ASSETS
Personal property is everything that is not real property, and typically includes furniture, equipment, airplanes, trucks and computers. Personal property that is held for productive use in a trade or business or for investment purposes can be exchanged for like kind replacement personal property. The Federal Regulations provide a safe harbor for personal property in the same asset class; meaning that assets that fall within the same asset class are deemed to be like kind. If the assets don not fall within the same assets class, they may still be considered “like kind” if they fall within the same product class.
Even if personal property assets are not in the same asset class or product class, the assets still may be considered like kind for purposes of the exchange if the assets are similar enough to each other. For example, an SUV has been held to be like kind to a passenger automobile, and fishing permits for a particular species and a particular location have been held to be like kind to fishing permit for another species and location. Personal property that is not like kind under the rules described above cannot be exchange. For example, an investor may own a tractor worth $50,000 and an airplane worth $95,000. The tractor can be exchange for another tractor, and the airplane for another airplane. However, because a tractor and an airplane do not fall within the same classification and are not similar enough to be like kind, the investor cannot combine the proceeds of the sale of these two items to purchase an airplane worth $145,000 and successfully defer taxes on all of his gain.
Farm Equipment: Machinery such as combines, cotton gins, feed processing equipment, plows, farm tractors, haying, and machinery, milking machines, and poultry feeding and watering equipment all fall under same product class. Therefore, items within this product class can be exchange for each other. For example, a $50,000 combine and a $25,000 plow can be exchange for a $75,000 haying machine.
Livestock: Livestock held for sale in the ordinary course of business is inventory and cannot be exchanged; however, livestock that is owned for a dairy operation or for breeding purposes can be exchanged. The like kind requirement for livestock are very particular. For example, one-half blood heifers have been held to be like kind to a three-quarter blood heifers, but under the §1031(e) livestock of different sexes are not considered like kind.
Wai-Yew Lam, President
TREC Certified Instructor
Adelphi Retirement Management, LLC.