1031 Exchange: an essential tool for the business owner.

• Author: Spiess, Ben
• Position: Legal Speak

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In the technical world of the Internal Revenue Code, there's one provision every business owner has heard of--Section 1031.

It's the exception to the rule that asset sales are subject to capital gains tax. Under Section 1031, certain assets, in particular commercial real estate, can be sold and reinvested in similar, "like-kind" property tax-free without limit.

The pros are undeniable: deferral of taxes and increased cash flow for investment. The cons are strict regulations, harsh timelines, reduced basis, and the risk of an increased capital gains tax rate in the future.

Million Dollar Example

A simple example: a business owner buys a small office building for $500,000. Over ten years, the property has increased in value to $1,000,000. Now, the business owner wants to sell.

Assuming depreciation of $100,000, total federal capital gains tax would be $90,000, leaving the business owner with $910,000 after taxes. With a 1031 exchange, the entire $1,000,000 could be reinvested in a new commercial property. There is no limit on how many swaps an owner can make, deferring capital gains indefinitely.

The key requirement is that the replacement property into which the money is invested be "like-kind." However, for real estate, the definition of like-kind property is broad: any domestic real estate that is held for productive use in a trade or business or held for investment purposes can be exchanged for any other property. For example, raw land could be swapped for a shopping center, or an office building for apartments.

Having given these generous provisions, the 1RS then gets strict. Key regulations and timelines require the following:

* The business owner must identify replacement properties within 45 days and must acquire the property within 180 days.

* The same entity that sold the property must acquire the new property, but note the taxpayer can purchase the replacement property using a disregarded entity such as a pass-through single-member LLC, in which case the taxpayer is still deemed the owner.

* In general, the basis...