Can You Do a 1031 Exchange When Selling a Business?

A 1031 exchange allows investors to defer capital gains taxes when exchanging one investment property for another. While simple for single real estate assets, its application to business sales often raises questions. A business entity generally does not qualify for a 1031 exchange. However, certain underlying assets within a business can be eligible. This article clarifies which specific assets qualify and how such exchanges can be structured for tax deferral.

Understanding 1031 Eligibility for Business Assets

The ability to defer taxes through a 1031 exchange depends on the property type. A fundamental distinction exists between real property and personal property. The Tax Cuts and Jobs Act (TCJA) of 2017 limited eligibility exclusively to real property. Previously, certain personal property also qualified. Now, only real property held for productive use in a trade or business or for investment can be part of a 1031 exchange.

Real property, in this context, encompasses land, improvements, and unsevered natural products. It also includes structures permanently affixed to land, such as buildings, walls, floors, and plumbing systems. For a business, qualifying real property includes commercial buildings where operations are conducted, land, or warehouses.

Interests in a partnership or an LLC taxed as a partnership are excluded from eligibility. Corporate stock also does not qualify. Additionally, inventory or property held primarily for sale, such as goods a business sells, cannot be exchanged under Section 1031.

Intangible assets, like goodwill or intellectual property, are also ineligible. Treasury regulations clarify that a business’s goodwill or going concern value is not like-kind to another business’s. While a business entity itself cannot be exchanged, careful planning can allow for the exchange of its qualifying real property assets.

Tangible personal property, such as equipment, machinery, vehicles, and office furniture, no longer qualifies for 1031 exchange treatment after the TCJA. These assets often comprise a substantial portion of a company’s value. Therefore, any gain on their sale is immediately taxable.

Structuring a Business Sale for 1031 Benefits

When a business is sold, its structure dictates potential 1031 exchange benefits. For an exchange to occur, the sale must involve specific business assets, not the entity itself. Corporate stock sales are not eligible for a 1031 exchange.

A key step is allocating the total sale price among the business’s assets. This assigns values to real property, tangible personal property, intangible assets, and goodwill. Only the portion allocated to qualifying real property can be considered for a 1031 exchange. Remaining proceeds from non-qualifying assets are immediately taxable.

The real property component of a business sale is treated as a distinct transaction for 1031 purposes. This separation is crucial, even if acquired as part of a larger business acquisition. The seller must identify the real property being sold and the corresponding replacement property to facilitate the exchange.

For sole proprietorships, delineating real property assets for exchange can be simpler. A sole proprietorship is not a separate legal entity from its owner, so real property is typically held directly by the individual. This direct ownership simplifies identifying and exchanging qualifying real property assets.

Partnerships and LLCs taxed as partnerships present more complexity. An interest in a partnership or LLC itself cannot be exchanged under Section 1031. However, the underlying real property held by the entity can sometimes be exchanged. Strategies may involve the entity performing the exchange directly or distributing the real estate to partners or members as tenancy-in-common interests before the exchange.

Such complex arrangements require careful planning and often involve legal and tax professionals for IRS compliance. The goal is to isolate the real property component of the business. This allows the seller to potentially defer capital gains taxes on that specific portion through a properly executed 1031 exchange.

Key Considerations for Business-Related 1031 Exchanges

Executing a valid 1031 exchange for real property in a business sale requires adherence to specific rules. A Qualified Intermediary (QI) plays a central role, holding proceeds from the relinquished property sale. This ensures the taxpayer does not have actual or constructive receipt of funds, preventing immediate taxation.

Two timing rules govern 1031 exchanges. First, taxpayers must identify potential replacement properties within 45 days of transferring the relinquished property. This identification must be in writing and clearly describe the properties. Second, the replacement property must be acquired, and the exchange completed, within 180 days of the relinquished property’s transfer, or by the tax return’s due date (including extensions), whichever comes first. Both deadlines are strict and generally cannot be extended.

The “like-kind” requirement for real property is broadly interpreted, signifying the property’s nature or character, not its grade or quality. Any real estate held for investment or productive use in a trade or business can be exchanged for any other real estate held for the same purposes. For instance, a business’s office building could be exchanged for a rental property, or a manufacturing facility for a retail space.

The receipt of “boot” can trigger taxable gain in an otherwise tax-deferred exchange. Boot refers to any non-like-kind property received, such as cash, an installment note, or personal property. It also includes debt relief if the replacement property’s mortgage is less than the relinquished property’s. If boot is received, gain is recognized to the extent of the boot, but the entire exchange is not disqualified.

Taxpayers must report the 1031 exchange to the IRS on Form 8824, “Like-Kind Exchanges.” This form provides details about both relinquished and replacement properties, including acquisition and identification dates, and calculates any deferred gain or recognized boot. Proper and timely filing is essential to ensure tax deferral is recognized by the IRS.