Deferring Capital Gains Taxes on Business Property

The tax deferred exchange provides real estate owners with one
of the last true tax breaks and the only method of deferring tax
on the sale of investment and business property. Most
taxpayers know they can exclude the gain on a sale of their
personal residence. Unfortunately, many business and
investment property owners fail to capitalize on the benefits of
another type of tax-deferred exchange, under Internal Revenue
Code Section 1031.

Far too many business owners sell their business and
investment property and pay capital gain taxes because they are
unaware of provisions in the tax code that allow for deferral.
Internal Revenue Code Section 1031(a)(1) states in part that
"no gain or loss shall be recognized on the exchange of
property held for productive use in a trade or business or for
investment if such property is exchanged solely for property of
like kind which is to be held either for productive use in a trade
or business or for investment." Examples of property types that
typically qualify are vacant land, office buildings, warehouses,
farmland, single-family rental units and shopping centers. Even
leases with 30 or more years remaining are considered real
property and can be traded for other real property.

How does one get started? The procedure is fairly simple as
Treasury Regulations issued in April of 1991 provide a
guideline for taxpayers to follow. Once a buyer for the property
to be sold (the "relinquished property") has been found, a
phone call to a selected "qualified intermediary" to assist with
the Section 1031 exchange is all it takes to begin the process.
The qualified intermediary will produce the necessary legal
documentation required to facilitate the exchange process.
Once the closing of the relinquished property has occurred, the
taxpayer has 45 days from the date of closing to identify in
writing to the intermediary the possible replacement properties.
Due to significant restrictions, it is usually best to identify no
more than three replacement properties. The final step is to
close on one of the identified properties within 180 days from
the date of closing of the relinquished property.

Although the 1031 tax code section is very liberal, various
modifications over the years have resulted in a few additional
restrictions. Partnership shares, notes, stocks, bonds,
certificates of trust cannot be exchanged. A taxpayer who holds
a partnership interest or shares in a corporation that owns real
estate cannot trade that interest for similar share interests.
Business owners should consult a tax expert or legal advisor in
this situation.

With the reduction in capital gains tax rates, taxpayers were
given a rare break. However, this break was not as generous as
originally proposed. Most taxpayers are aware of the new
capital gains tax rate of 15 percent, lowered from the previous
28 percent rate. This is applicable for gain generated from the
sale of capital assets held for more than 12 months. At the last
minute, however, Congress altered the tax rate for recapture of
depreciation taken on real estate to be taxed at 25 percent. This
higher rate is applicable for all depreciation taken after May 6,
1997. Combining the 25 percent depreciation recapture rate
with state and federal tax rates could cost a taxpayer who sells
business real estate over to 40 percent or more of their profit.
On the other hand, a property owner who chooses to perform
an IRC Section 1031 tax deferred exchange can defer taxes on
the all of the capital gain! This leaves the prudent exchange or
with the entire amount available for reinvestment.

Many business owners are unaware that personal property used
in a business, such as a medical practice, can be exchanged as
well. The major difference between a real property and
personal property exchange is what the Internal Revenue
Service considers "like kind" property. I.R.C. Section 1031
defines like kind as "...property held for productive use in a
trade or business or for investment." Like kind as it applies to
real property is very broad in definition. Determining whether
personal property is like kind to other personal property
requires a much narrower scope. The Internal Revenue Code
does not define "like kind." The IRS has published regulations
that can be used to decide if an exchange involves like-kind
properties. The Treasury Regulations distinguishes between
two types of personal property: depreciable tangible personal
property (DTPP); and other personal property (OPP), which
consists of intangible and non-depreciable personal property.
DTPP can only be exchanged for other DTPP. These properties
must be of a "like class" or "like kind." In determining whether
DTPP is of a like class the Treasury Regulations designate 13
general asset classes. These classes combine particular types of
personal property into a certain class group. Some examples of
these groups are office furniture and fixtures, information
systems, airplanes and helicopters, automobiles and taxis, and
buses.

The Regulations also designate that personal property can fall
within product classes contained in the North American
Industry Classification System. These numeric codes can be
used as an alternate method to define the characteristics of a
particular property.

OPP is difficult to classify as like kind to other OPP. It does
not fall within the like class safe harbor available to DTPP.
Intangible personal property, such as a lease or copyright, can
be considered like kind to similar intangible property. The
determining factors are the nature and character of the rights
involved and the nature and character of the underlying asset.
Selling a business can create more than one personal property
group in which to exchange. The IRS looks at the sale of a
business as an exchange of each asset to be transferred, and not
the exchange of the business as a whole. The underlying assets
of a business (e.g., lease value, covenant not to compete,
equipment and fixtures) will need to be analyzed in respect to
their comparable replacement property. Each asset is placed
into the proper exchange group. An exchange group is a
subgroup of the total assets exchanged. Every exchange group
will either have a surplus (trading up in value) or a deficiency
(boot). When the total fair market values of the properties
exchanged are different, the value equal to that difference is
called the residual group. The property in the residual group
will consist of cash and other property that does not fit into an
exchange group.

An example of a business exchange would be the exchange of
one medical practice for another. The relinquished medical
practice value consisted of: (1) the medical equipment (x-ray
machines, etc.) and office fixtures; (2) a covenant not to
compete; (3) lease value for the below market lease of the
office; and (4) client patient lists and files. The medical
practice acquired will generally have similar components of
value. To balance this exchange each separate component is
matched up with its like kind counterpart. A surplus in one of
the exchange groups is not taxable as the Regulations allow for
trading up in value. Any deficiency - going down in value -
would be taxable as "boot."

The Regulations provide the non-yielding rule that goodwill
and going concern value in one business can never be like in
kind to goodwill and going concern value in another business.
In the example of the medical practice exchange, the client
patient lists and files would probably be viewed by the IRS as
goodwill, and should not be included in the exchange. A
prudent tax planner would attempt to allocate value to the
depreciable or amortizable personal property, such as the
medical equipment and office fixtures, to avoid this problem.
Additional personal property not eligible for exchange
treatment is inventory. The inventory of a business is held for
resale and does not fall within the definition of Section 1031
property.

Anyone considering deferring tax under IRC Section 1031
should obtain competent tax/legal advice before proceeding
with a transaction. A mistake can be costly.

Deferring Taxable Gain on the Sale of Your Business Or Real Estate Assets

Business owners who sell a business, assets held or used in their business, or real estate used in their business operations can face significant capital gain taxes.  These capital gain taxes due from the sale of your company, assets or real property can be minimized or even eliminated with the proper tax deferral or tax exclusion planning in conjunction with your legal and tax advisor. 

There are numerous tax deferred and/or tax exclusion strategies available for the sale of businesses, assets and real estate.  It is critical that careful tax planning be a priority in order to properly deal with the potential capital gain taxes that will be generated by the sale of your property.

The 1031 Tax Deferred Exchange May Not Be Suitable

Owners of real or personal property, such as a business interest, assets used in a business or real property that have been held for rental, lease, investment or used in a trade or business, frequently structure tax-deferred exchanges pursuant to Section 1031 ("Section 1031") of the Internal Revenue Code ("Code") in order to defer the payment of their taxable gains.

However, tax-deferred exchanges pursuant to Section 1031 are not always feasible, suitable nor appropriate for taxpayers when they are selling their company, assets used in their company or real property used in their business operation. 

Section 1031 Exchange transaction structures require business or property owners to exchange equal or up in net sales value by acquiring one or more replacement properties that are of like-kind.  Locating suitable replacement properties to be acquired as part of the Section 1031 Exchange in order to replace the relinquished property (business) can be extremely challenging, very stressful, and virtually impossible in some cases. 

The taxpayer may have absolutely no wish to reinvest his or her net sale proceeds into another business operation of like-kind, or any kind, for that matter.   Taxpayers may just wish to "cash out" and pay their taxes. 

Taxpayers may have reached a point in their life when they merely wish to sell, cash out, pay the taxes, and absolutely not reinvest in another business, assets or real estate. They may not even want to see another business as long as the live.  Some taxpayers may opt to sell and pay their capital gain taxes in the current year, but many would prefer to implement some kind of tax deferral or tax exclusion strategy that would allow them to defer the payment of their taxable gains over a period of time of their choosing rather than get hit with them all in the year of sale.

Deferring Capital Gain Taxes Without a 1031 Exchange

There are a number of tax deferred and tax exclusion strategies available that a taxpayer can use to defer the payment of taxable gains, so it is important that the taxpayer meet with his or her tax advisor to review all of their tax strategies. The following are the two most common tax-deferral strategies available for the sale of businesses, assets used in your business or real estate:

Seller Carry Back Note (Seller Financing)

The taxpayer could structure the sale of his or her business operation by carrying back a note, which is often referred to as seller financing or a seller carry back note. Seller financing is merely an installment note or promissory note where the buyer of the business entity or assets/property makes periodic payments to the seller. Depreciation recapture taxes, if any, are due and paid in the year the business, assets or real estate were sold. The capital gain taxes are partially or fully deferred over the term of the note and are taxed as principal loan payments are made to the taxpayer.

The installment note or promissory note strategy has positive and negative features. The obvious positive is that you can sell your business, asset or property and defer the payment of your taxable gains by structuring a seller carry back note.

However, the risk of buyer default on the installment note is a considerable negative. The process to foreclose or otherwise take back the business or asset/property can consume significant amounts of time and money and the business, asset or property may have been irreparably damaged during the buyer's ownership and management.

Deferred Sales Trusts or DSTs

Deferred Sales Trusts or DSTs are highly effective tax-deferred strategies, similar to the installment sale or seller carry back note, but without the risk of buyer default.  The Deferred Sales Trust receives all of the net cash proceeds from the buyer at the closing of the sale transaction, thus removing the buyer from involvement in the Deferred Sales Trust  transaction.  Deferred Sales Trusts can provide other great tax and estate planning strategies as well.

Deferred Sales Trusts are drafted pursuant to Section 453 of the Internal Revenue Code, just like the installment sale note or promissory note in seller financing. The capital gains tax is realized or triggered, but not recognized or paid, because it is deferred over a period of time selected by the taxpayer.

The capital gains tax liability is partially or fully tax deferred over the term of the installment sale note created within the Deferred Sales Trust account, which you will negotiate in advance directly with the Trustee of the Deferred Sales Trust.