Can I Buy a Business With a 1031 Exchange?

When James Alderson and his wife, Clarissa, sold Buena Park in California to a business, they planned to smoothly acquire Salinas as the replacement property in a 1031 exchange and defer capital gains tax. Unfortunately, they had one problem: the Internal Revenue Service (IRS) had a different interpretation of what a “like-kind” exchange truly meant, subjecting the couple to a two-year tumultuous legal battle where they eventually became victorious.

This case was decades ago, but it remains a significant reference for caution when buying a business through a 1031 exchange. So yes, you can buy a business with a 1031 exchange. But the IRS views businesses differently from real estate, and not working with experts or understanding the nitty-gritty involved may expose you to immediate tax liabilities.

Universal Pacific 1031 Exchange has 35+ years of professional experience in helping individuals, entrepreneurs, business owners, and real estate investors buy and sell real estate properties while deferring capital gains taxes. We are a trusted Qualified Intermediary (QI) in Los Angeles that facilitates our clients’ 1031 exchanges in a highly-compliant manner that will prevent IRS scrutiny. Book a free consultation today to learn how we can help you grow your real estate investment and maximize profit.

In this article, we explained the meaning of a 1031 exchange and discussed the rules and guidelines for buying properties from businesses through this process.

What Is a 1031 Exchange?

A 1031 exchange is a powerful tax deferral strategy backed by Section 1031 of the tax law that allows individuals and entities to sell off their existing real estate properties and buy replacement commercial property of similar value without paying immediate capital gains tax. The numerous 1031 exchange benefits make it the go-to strategy for real estate investors who want to diversify their real estate portfolio and grow generational wealth tax-free. 

However, the Internal Revenue Service has strict compliance regulations, ensuring that only transactions that follow the tax code to the letter are eligible for these benefits. A slight deviation or non-adherence to the stipulated guidelines will lead to the disqualification of a transaction as a 1031 exchange. 

Most notable of these eligibility requirements is that only real estate properties can be exchanged through this means. Also, all proceeds from the sale of a relinquished property will be invested in buying or improving the new commercial or rental property. Taking part of the realized proceeds from the sale will lead to immediate tax liabilities.

Can I Buy a Business With a 1031 Exchange?

Yes, you can buy a business with a 1031 exchange if it comprises solely commercial or rental properties. This is because, according to the tax code, a 1031 exchange can only be used to purchase real investment property. However, most businesses that own real estate properties also have other assets like furniture, vehicles, and even heavy-duty equipment. These assets are not commercial properties and do not meet the “like-kind” requirements.

For the Internal Revenue Service to ratify your 1031 exchange, you need to buy only the real properties of the business through this means and may proceed to pay cash for other non-real estate assets of the business you’re interested in. While the qualifying like-kind properties give you immediate tax deferral benefits, you will pay immediate tax for the other assets you purchased that don’t qualify for the exchange.

Like-kind properties mean assets of the same nature or classification, which in this context is commercial or rental properties. As such, you can sell any real property set aside for investment purposes and buy any other commercial property, whether it’s the same type or not. 

This means the relinquished property may be a shopping mall, apartment building, skyscraper, manufacturing facility, or even a warehouse, while the replacement property could be any of these, a hotel, motel, apartment complex, or any other commercial property. The defining factor in the like-kind clause is that the asset must be one set aside for investment purposes. You cannot sell or buy a residential home through this means.

Are All Businesses Eligible for 1031 Exchanges?

No, not all businesses are eligible for 1031 exchanges. Only businesses that have commercial or rental properties are eligible to sell their assets through a 1031 like-kind exchange. Also, there is a difference between real estate owned by a business and the business itself. 

As we’ve discussed earlier, a business’s full asset list may comprise the real estate it owns and other kinds of assets, such as trademarks, copyrights, furniture, vehicles, and equipment. In this case, you cannot buy the entire business via a 1031 exchange. But you can purchase the business’s real estate holdings through this strategy.

Rules for Completing a 1031 Exchange for Business

What separates a successful 1031 exchange from a disqualified one is their adherence to the stipulated rules. These 1031 exchange rules include the following:

Property Must Be Like-Kind

The number one rule for completing a 1031 exchange for businesses is that the assets to be exchanged must be like-kind properties. This means you can only get an investment property(s) in exchange for your investment property. Trying to buy any additional asset class from a business through a 1031 exchange will lead to the disqualification of the transaction.

Strict Timeline

According to Section 1031 of the Internal Revenue Code (IRC), a like-kind exchange may be disqualified if it’s conducted outside the stipulated timeframe for 1031 exchanges. The rule requires you to find a replacement property within 45 days of the sale of the relinquished asset and complete the entire transaction within 180 days.

No Personal Property

Properties to be exchanged must be for commercial use only. Per the IRS rules, you cannot sell your vacation home or personal residence through this process. Similarly, only properties acquired for investment purposes and not for quick resale are eligible. To ascertain this, you must have held the property for a reasonable period, preferably between 12 – 24 months, before initiating the 1031 exchange. You need to keep the asset for the duration after the sale.

Equal or Greater Value

In order to defer capital gains taxes in a 1031 exchange, you must not take a dime from the proceeds of the sale of your relinquished property. Any profit you receive is known as cash boot and would require you to pay immediate tax on it. Hence, if you’re selling an asset for $400,000 to buy a new one, the transaction must be such that at the end, the entire sum realized from the sale will go into buying and improving the new property. 

To achieve this, you need to go for a replacement property with the same or higher fair market value (FMV) as the one you sold. If the new property you chose is worth $450,000, you will have to add an extra $50,000 to the realized proceeds to facilitate the purchase.

Same Taxpayer

The “same taxpayer” rule means that the individual or entity selling the relinquished asset must be the same one buying the new property. Non-adherence to this regulation has led to the disqualification of several Section 1031 transactions.

As such, before commencing the process, you must ensure that the property title is in your name and that the new property being purchased also bears your name. Any disparity in the documentation will void the transaction and open you up to immediate tax implications. If there is a need to change ownership before the sale, try to do it 12 – 24 months in advance.

Documentation Is Crucial

Apart from the title document, several other documents are critical to the successful completion of 1031 exchanges in a manner that the IRS deems satisfactory. Your Qualified Intermediary will create some of these documents during the sale of the old property and the purchase of the new property. All documents, including receipts, must be carefully maintained as they will be relevant to prove your case during any IRS scrutiny.

How Do You Use a 1031 Exchange to Buy Business Property?

Buying a business property through a 1031 exchange requires a step-by-step approach, which involves adhering to the rules we’ve discussed and working with a reliable QI. These are relevant steps to follow to guarantee a smooth 1031 exchange process:

1. Verify Eligibility for a 1031 Exchange

The pathway to a successful 1031 exchange is adhering to all the rules and regulations guiding the process. This includes verifying the ownership of the property and ensuring that you’re selling your asset for investment use. Most importantly, you must ensure that both properties to be exchanged are like-kind. You cannot buy a non-real estate asset from the business through a 1031 exchange.

2. Connect With a Qualified Intermediary

A Qualified Intermediary is a neutral individual or entity empowered by Section 1031 of the IRC to execute 1031 like-kind exchanges. The QI must not be related to you by family and must have no business or employment relationship with you over the past two months. Their job is to prepare necessary documentation, facilitate the sale of your relinquished property, handle the proceeds, and complete the purchase of a new one.

So, without a QI, you cannot conduct a 1031 exchange. Some QIs go the extra mile to offer you the requisite advice to simplify the entire process while helping you avoid common compliance mistakes that can jeopardize a transaction. If this is what you need, book a free consultation now to speak with an experienced QI.

3. Sell the Existing Business Property

The next step is to list your property for sale. Once a willing buyer is found, the QI will prepare the relevant documentation, such as the exchange agreement, assignment of sale contract, instructions to escrow or closing agent. 

Also, the QI will go ahead to create a segregated escrow account for the transaction. This move is to ensure that no payment is made directly to you. Any funds sent to you from the buyer for the property will be viewed as a constructive receipt of income. This will automatically void the 1031 exchange and make you liable for immediate tax payment. 

Hence, the sale proceeds will be sent to the escrow account the QI created and will remain there until it’s time to buy the replacement property.

4. Identify Replacement Property Within 45 Days

Finding a replacement property shouldn’t be a hassle. You may hire a real estate agent, broker, or CPA to curate a list of worthy replacement properties within your preferred locations. The QI shouldn’t advise you on the replacement property to get, as this will void their neutral status. Rather, their job in this context is to help you ensure IRS compliance by vetting the list of replacement properties your agents or broker curated. All this must be done within 45 days.

5. Complete the Purchase Within 180 Days

If the properties meet the eligibility criteria, the QI will proceed to purchase any of them. In some cases, you may sell one property to buy multiple properties. This can work if the combined value of the two properties is equal to the FMV of the one you sold. Otherwise, you will stick to one-to-one exchange.

The QI will also prepare the right documentation for the purchase and coordinate all relevant stakeholders to ensure the purchase reflects the tenets of a 1031 exchange. Once everything is good, the QI will release the funds from the escrow account to the seller. All this must happen within 180 days of the sale of the relinquished property.

Need a Qualified Intermediary to Defer Capital Gains Tax?

So far, we’ve seen that you can buy a business through a 1031 exchange only if the business consists solely of commercial or rental properties. If the business has other assets, you can only purchase its real estate holdings designated for investment use.

The entire process can be dicey, and taking the wrong move would disqualify the transaction from capital gains tax deferral. That’s why it’s important to work with seasoned professionals with verifiable experience in handling 1031 exchanges.

Universal Pacific 1031 Exchange is a specialized firm focused on helping entities facilitate successful like-kind transactions by offering top-tier Qualified Intermediary services. With over three decades of active experience, we have all it takes to help you circumvent the rigors of the process and protect you from errors that would constitute IRS penalties.

Book a free consultation or visit any of our 1031 exchange offices in Los Angeles to start an exchange today.