Can an S Corp Do a 1031 Exchange?

An S corporation can undertake a 1031 exchange, deferring capital gains taxes on qualifying property. This strategy combines the pass-through taxation benefits of an S corporation with the tax-deferral advantages of a like-kind exchange. This article explores the foundations of S corporations and 1031 exchanges, outlines the process for S corporations to execute such exchanges, details unique tax considerations, and highlights common factors.

Foundations of S Corporations and 1031 Exchanges

An S corporation is a business structure that allows income, losses, deductions, and credits to pass directly through to its shareholders for federal tax purposes. This avoids the double taxation found in C corporations, where profits are taxed at the corporate level and again when distributed. Shareholders report these flow-through items on their personal tax returns.

A 1031 exchange, also known as a like-kind exchange, enables investors to defer capital gains tax when selling certain types of investment or business property. This is done by reinvesting the proceeds into similar property, as outlined in Internal Revenue Code Section 1031. The exchange must involve real property held for productive use in a trade or business or for investment.

An S corporation can undertake a 1031 exchange, provided it meets the requirements of the Internal Revenue Code. This allows the S corporation to defer capital gains taxes on the sale of qualifying real property, aligning with its pass-through nature and offering financial planning opportunities.

Executing a 1031 Exchange as an S Corporation

When an S corporation undertakes a 1031 exchange, the corporation itself acts as the exchanging party, not its individual shareholders. The relinquished property must be owned by the S corporation, and the replacement property must also be acquired by the S corporation. Both properties must be “like-kind,” meaning real property held for productive use in a trade or business or for investment. This allows for diverse property types, such as exchanging an apartment building for raw land.

A Qualified Intermediary (QI) facilitates a 1031 exchange to ensure IRS compliance. The QI holds the proceeds from the sale of the relinquished property, preventing the S corporation from having constructive receipt of the funds. The QI prepares documentation, coordinates with closing agents, and safeguards exchange funds in a segregated account.

After the sale of the relinquished property, the S corporation has 45 calendar days to identify potential replacement properties. This identification must be in writing and delivered to the QI, clearly describing the properties. The S corporation then has a total of 180 calendar days from the sale of the relinquished property to acquire the replacement property. Both the 45-day identification period and the 180-day exchange period run concurrently.

Unique S Corporation Tax Implications

While a 1031 exchange defers gain at the corporate level for an S corporation, it impacts shareholders’ stock basis. The deferred gain does not immediately increase a shareholder’s basis. However, the basis of the newly acquired replacement property at the S corporation level will influence future depreciation deductions and the calculation of gain or loss upon a subsequent sale. This deferral means tax liability is carried over to the replacement property’s basis.

The Built-In Gains (BIG) tax under Internal Revenue Code Section 1374 applies if the S corporation was previously a C corporation and disposes of appreciated assets from its C corporation years. If the exchanged property held appreciated value when the S election was made, and the exchange occurs within the five-year recognition period, a corporate-level tax may apply.

The BIG tax is imposed on the net recognized built-in gain. A tax-deferred like-kind exchange does not trigger the built-in gain inherent in that asset, except for any “boot” received. Instead, the unrecognized built-in gain and the unexpired portion of the recognition period transfer to the asset received in the exchange. If no boot is received and the new asset is held until the recognition period expires, no built-in gain is recognized at the corporate level.

Depreciation recapture, while general to 1031 exchanges, impacts S corporation shareholders due to its flow-through nature. When an S corporation sells a depreciated asset, the gain attributable to previously claimed depreciation is subject to recapture. The 1031 exchange defers this recapture, carrying the deferred depreciation from the relinquished property over to the replacement property. When the replacement property is eventually sold, the accumulated depreciation recapture will flow through to the shareholders, potentially resulting in ordinary income.

Common Considerations in S Corp 1031 Exchanges

Receiving “boot” in a 1031 exchange can trigger immediate taxation. Boot refers to any non-like-kind property received by the S corporation, such as cash, debt relief, or property that does not qualify as like-kind. The gain recognized due to boot flows through to the S corporation’s shareholders. To fully defer capital gains taxes, the S corporation must reinvest all proceeds from the sale into the replacement property and avoid receiving boot.

Exchanges involving related parties are subject to rules under Internal Revenue Code Section 1031. If an S corporation exchanges property with a related party, and either party disposes of their property within two years, the deferred gain could be recognized immediately. Related parties include family members, or corporations and partnerships with more than 50% common ownership. These rules prevent related parties from shifting tax basis between properties to avoid tax.

Property held primarily for sale, such as inventory or dealer property, does not qualify for a 1031 exchange. The intent of the S corporation at the time of acquiring and holding the property is a determining factor. If the property was acquired with the intent to sell rather than for investment or productive use in a trade or business, it will not qualify for tax deferral under Section 1031.