Tax Strategy to Eliminate Barrier to Growth

The 1031 exchange can be used to defer taxes on the sale of many kinds of assets

Everybody complains about taxes and small business owners are no exception. But they may have a bigger beef than other taxpayers. Why? Because, increasingly, the fear of tax consequences convinces business owners to postpone or even forego expansion plans.

This is particularly so when it comes to investing in new facilities. If you own your factory or office building, the capital gains taxes you will pay on the appreciated value of the property when you sell figures heavily into the net profitability of the expansion. If you expect your profits to increase $150,000 per year in a larger location, but the capital gains tax liability from the sale of your existing location is $300,000, there may be a decision against the expansion.

But what many business owners don’t realize is that a so-called 1031 Exchange, named for a section of the Internal Revenue Code, can tilt the scales back toward expansion by deferring taxes. The rule, which is widely used by real estate investors, lets you roll over the tax liability into the new property. In fact, a business owner can use the same techniques to reduce taxes on the sale of other assets, such as machinery, too.

The 1031 exchange has become so popular among professional real estate investors that it is now viewed as one of the reasons behind the commercial real estate boom. You can see why: If a building was purchased for business or investment purposes for $200,000, and thereafter sold for $800,000, the investor would have a $600,000 capital gain. The tax liability for this sale could be more than $200,000 when combining city, state, and federal capital gains tax and depreciation recapture. Instead of paying the tax the money is instead used to help purchase the new property.

And, if you take the tax bite out of the transaction, you set the stage for a much more dynamic market—like we have seen in recent years. An IRC Sec. 1031 exchange allows owners of business or investment property to defer recognition of capital gains tax as long as they buy a property of equal or greater value, and utilize all their net proceeds from the sale toward the purchase of a “like kind” property. And, you can continue to do exchange after exchange and continue to defer the recognition of capital gains. This is a long term strategy for growing your business. (For details of the law, see this previous story.).

What about other kinds of assets? Virtually any type of business asset can be exchanged as well. Consider a construction company which purchases a heavy crane for $600,000 and later sells it for $400,000. Due to depreciation, which is an offset against income for the normal wear and tear of property, the basis upon the sale of the crane could be as low as $200,000, meaning that there is a $200,000 gain upon the sale ($400,000 sale price - the $200,000 basis = a $200,000 gain). The tax upon the sale of this crane could be at least $50,000. But if the $400,000 goes toward the purchase of a new crane, the tax is deferred. You can see how widely applicable the concept is: Think about a delivery company that has many trucks, or a bus company, or a manufacturer with expensive equipment, or even a restaurant with expensive kitchen equipment. All these items will yield a capital gains tax upon their sale.

There are even some intangible items that can be exchanged as well. Most notable among these are franchise rights. If you purchased a franchise right to flip burgers in a certain geographic location for $200,000, and later you are selling your business and valuing the franchise rights at $1 million, you would have a gain of $800,000, with a tax bill of at least $160,000. If you were to buy another similar franchise using the proceeds from this sale it would be possible to defer this gain.

When contemplating these types of the exchanges it is necessary to retain the services of a qualified intermediary. Qualified intermediaries act as an independent third party to help structure IRC §1031 tax deferred exchanges, and are responsible for preparing the necessary documentation, as well as acting as the escrow agent for the exchange funds. It is also a good idea to retain the services of a knowledgeable attorney and CPA to help guide you through the transaction.

Todd Pajonas is president of Security 1031 Services, Inc. a Qualified Intermediary based in New York http://www.sos1031.com/