A 1031 exchange is commonly used for real estate investment transactions but can also be used to buy a business.
Investing in a business can be costly when considering the tax implications. That is why a 1031 exchange is appealing when you want to buy a business with funds from selling an investment property. In a 1031 exchange, you can defer the payment of capital gains taxes on the sale of a property or business when replacing it with a like-kind investment.
Like-Kind Properties
The property you are selling in the exchange must be a like-kind investment to the business you are purchasing. A like-kind property must be equal to or less than the relinquished investment.
It is easiest to invest in a similar business, but it is possible to exchange a different type of property, like a rental property, into purchasing a business. For example, selling a duplex and replacing it with a commercial property or relinquishing farmland and investing the funds into a storefront.
The exchange must be for like-kind properties or businesses within the United States. Also, when investing in a business with a 1031 exchange, you cannot use the exchange funds for things like inventory.
You can also use a 1031 exchange for the sale and purchase of a specific category of business, like a franchise or chain of stores. For example, you can do an exchange on a franchise in one market for one in another market. A similar business can replace a national business, like a national car dealership chain, with another car dealership chain.
IRS Form 8824
In any like-kind 1031 exchange, a Form 8824 must be completed with the IRS. You file the form with your federal tax returns in the year that the original investment is relinquished.
Steps in a 1031 Exchange
When completing a 1031 exchange, the steps are generally the same, whether you are buying real estate or a business.
- Decide to complete a 1031 exchange on a property or business you own.
- Develop a strategic tax plan with an advisor or Qualified Intermediary (QI).
- Put the property that will be relinquished on the market.
- If you haven’t already, identify the replacement investment(s). You must identify the replacement investment within 45 days of the close of the relinquished property.
- Close the relinquished property transaction.
- Sign a contract for the replacement property.
- The QI will work with the title company.
- Close on the identified replacement property within 180 days of closing on the relinquished investment.
Obviously, this is a high-level overview of the steps, but it gives you an idea of the general process of buying a business with a 1031 exchange.
The IRS provides more details on buying a business with a 1031 exchange in IRS Publication 544.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
