Can I Buy a Business With a 1031 Exchange?
Explore the strategic use of a 1031 exchange in a business purchase by separating the real estate value from other assets to achieve tax deferral.
A 1031 exchange provides a path for deferring capital gains tax on the sale of certain properties. Formally recognized under Internal Revenue Code Section 1031, this strategy allows an investor to postpone paying tax on the gain from a sale if the proceeds are reinvested into a similar type of property. This raises a common question for entrepreneurs and investors: can this tax deferral be applied to the purchase of an entire operating business? Understanding the rules reveals how a 1031 exchange can be a component of a business acquisition strategy.
Qualifying Assets in a Business Purchase
An investor cannot use a 1031 exchange to purchase an entire operating business in a single transaction. The regulations limit this tax deferral to the exchange of “like-kind” properties, and since the Tax Cuts and Jobs Act of 2017, this has been narrowed to only include real property held for business or investment purposes. This means that while the real estate owned by a business—such as the office building, warehouse, or land—is eligible, the other components of the business are not.
The definition of real property includes land and anything permanently attached to it, like buildings and their inherent structural components. For example, an investor could sell a rental apartment building and use the proceeds through a 1031 exchange to acquire the commercial building from which a target business operates. This allows for a wide range of real estate types to be considered like-kind with each other.
A business sale involves a bundle of assets that are excluded from 1031 exchange treatment because they are not real property. These non-qualifying assets include:
- Goodwill, which represents the intangible value of a business’s reputation and customer base
- A company’s inventory, or goods held for sale
- Tangible personal property like equipment, machinery, and vehicles
- Intangible assets such as patents, trademarks, copyrights, and customer lists
The Importance of Asset Allocation
Successfully using a 1031 exchange as part of a business acquisition hinges on asset allocation. This is the formal procedure where the buyer and seller assign a specific monetary value to each asset being transferred in the sale. The total purchase price of the business is broken down and attributed to its various components, such as the real estate, equipment, inventory, and goodwill.
This allocation must be documented within the official purchase and sale agreement. This agreement becomes the controlling document for tax purposes, dictating how the transaction is reported to the IRS by both parties. The values assigned should be defensible and are often determined through independent, third-party appraisals, particularly for significant assets like real estate and specialized machinery.
The asset allocation directly determines the amount of taxable gain in the transaction. Any 1031 exchange funds used to acquire non-qualifying assets are known as “boot.” For instance, if the real estate of the acquired business is valued at $1 million, only that amount from the exchange proceeds can be applied tax-deferred. If the total business price is $1.5 million, the remaining $500,000 used to buy goodwill, equipment, and other assets is considered boot and is subject to immediate capital gains tax.
An improperly documented or indefensible allocation can attract scrutiny from the IRS. Both buyer and seller must agree on these figures, as they will need to file IRS Form 8594, Asset Acquisition Statement, reporting the same allocation of the purchase price across different asset classes.
Structuring the Exchange Transaction
The structure of the business acquisition is a determining factor; a 1031 exchange can only be utilized in an asset sale, not a stock sale. Section 1031 prohibits the exchange of corporate stock, interests in a partnership, or membership interests in an LLC. In an asset sale, the buyer acquires individual assets, allowing for the segregation of the qualifying real property from the non-qualifying assets.
To execute the exchange, the investor must engage a Qualified Intermediary (QI). A QI is an independent third party that facilitates the transaction by holding the sale proceeds from the original property. The investor is prohibited from having actual or constructive receipt of these funds, and the QI ensures the process complies with IRS regulations.
Once the relinquished property is sold and the funds are held by the QI, two deadlines begin. The investor has 45 days to formally identify potential replacement properties in writing to the QI. In a business acquisition, this identification must be specific to the real property component of the target business, referencing its allocated value from the purchase agreement.
The second deadline requires the investor to complete the purchase of the identified replacement property within 180 days from the date the original property was sold. At the closing of the business acquisition, the QI will release the exact amount of exchange funds needed to purchase the real estate directly to the seller.