PUTTING SECTION 1031 TO WORK
Business owners and advisors should be aware of the opportunity to enhance the value of the business real estate in any planned transaction. Value can be added with a tax-free exchange of operating business real estate for other income-producing property.
Section 1031 of the Internal Revenue Code provides that no gain or loss will be recognized when an owner of "like-kind" properties held for "productive use in a trade or business" of "for investment" is exchanged.
The opportunity is created because the definition of "like-kind" is broad enough to permit a variety of transactions to qualify. A manufacturing building in Pennsylvania may be exchanged for farmland in Florida, an apartment building in Rhode Island, or even mineral rights in Nevada. With high tax rates and fixed income investment returns decreasing it is imperative to employ tax planning tools to increase the amount of the seller's post transaction earning assets.
For example, a business owner's net equity in his or her building may have increased to $500,000 over the years. If the building is part of the initial or a subsequent transaction, the combined state and federal tax could exceed 40% of the gain. Reinvestment of the after-tax proceeds of approximately $300,000 could return less than $30,000 annually to the business seller. In most business sale situations, there is adequate time to complete an exchange, if the concept is introduced in a timely manner.
The IRS regulations require that the "replacement" property be identified within 45 days after the "original" property is sold and that the new property must be acquired within 180 days. With a typical business closing schedule and some careful planning, the seller of the business property could have up to 240 days to conduct the search, identify the property, and complete the exchange. Since the regulation permits identification of up to three potential replacement properties, the probability of concluding a successful exchange is markedly increased.
With the shrewd use of Section 1031 exchanges, a business seller could achieve additional savings. Income tax on the gain may be avoided during the seller's lifetime and even after death since the heirs would have a "stepped-up basis" in the real estate. (Unless the current congress changes this as a trade-off in the recurring "death tax" debate.) The estate executor could refinance the property or sell it to provide the necessary liquidity to meet estate obligations.
Although there are some complexities in the 1031 exchange program, the benefits are significant enough to require consideration in most estate planning situations. The IRS rules delineate the required 1031 exchange security arrangements, qualified escrow accounts, and trust arrangements. Beyond the tax savings and the opportunity to deploy more earning assets, there is one additional way that Section 1031 can help decrease the owner's resistance to planning a business sale.
Often a business owner has difficulty in making a decision to sell a business when a child is directly involved in the day-to-day operations. In such situations, it is often good advice to suggest that the business owner sell his or her business and purchase a smaller business that the son or daughter could manage. This approach creates liquidity, reduces overall business risks, and resolves the family conflict that may keep a business owner from making an appropriate decision to sell the business. The 1031 exchange can be used in this type of two-step transaction to accomplish the broader family and financial goals.
An early explanation of the exchange process and the related requirements is important. The market value of the original and the replacement properties should be supported by appraisals prepared by qualified appraisers of income and investment properties. Both the seller and the buyer of the business real estate should recognize the implication to their post-transaction tax positions. Since the real property owned by the business is often the subject of separate discussions, this critical valuation requirement should not introduce any new issues.
Naturally, the ultimate increase in value by application of these techniques will depend on the relative balance of the value of the various assets which are included in the transaction. For most mid-sized businesses it may be possible to add 10% to 20% to the seller's net after-tax proceeds. This difference may be significant enough to permit marginal sales to close more easily. Section 1031 exchanges, therefore, should become a standard tool for use by property owners and business owners in today's unique financial environment. The ability of the seller to save or defer income taxes, to keep more earning equity, and to initiate effective estate planning cannot and should not be overlooked.