As a savvy small business owner, you are used to making decisions that affect your bottom line. Everyone wants to make a profit, and every now and then you may find yourself in a position to sell off a business or a large asset. The problem is that each time a business is sold, it can create a large tax liability. However, something known as a “1031 Exchange” can help.
The Internal Revenue Service has created the Internal Revenue Code 1031, which allows businesses and individuals to defer the recognition of the capital gains or other taxes associated with the sale of most businesses or investment assets, as long as new assets are purchased to replace the existing ones. For the most part, just about every tax deferred exchange is structured as a real property or a personal property exchange.
As a business owner, you must be actively involved in the business that is being sold in order to take advantage of the 1031 Exchange. As with any other Internal Revenue Service code and regulation, understand the fine points can be tricky.
To qualify, the following requirements must be met:
- In each transaction, there must be at least two properties involved — the one that you are selling and the one that you are replacing it with.
- The properties involved do not have to be identical, but they must still qualify. In other words, they must be properties that are actively used in trade or business (an office building, warehouse, industrial space, etc.) or for investment (raw land or rental properties such as apartment buildings or condo units). Be advised that your personal residence does not qualify as a 1031 Exchange.
To be sure you are following IRS rules and regulations, it is helpful to have a real estate attorney or a “qualified intermediary” help you with the wording of the contract. According to the IRS, a qualified intermediary is “a person who enters into a written exchange agreement with you to acquire and transfer the property you give up and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary.”
It is important for the transaction to follow the letter of the law carefully. Therefore, contract wording is critical and must reflect your intent to perform a 1031 Exchange. The closing date for the new property must take place no later than six months after the sale or exchange of the other property. The IRS rules are very strict on these exchanges, so if you have any concern that you might be violating the code, seek the counsel of a tax attorney or other professional.