Can You Use a 1031 Exchange to Buy Your Business Property?

Section 1031 lets a taxpayer postpone gain when real property is exchanged for like-kind real property. IRS Publication 544 says the rules apply only to exchanges of real property held for investment or for productive use in your trade or business and not held primarily for sale, and that both the property you give up and the property you receive must be held by you for those purposes. Buildings, land and rental property are its examples.

So a company buying a building to occupy can be on the receiving side of an exchange, because a building used in your business is held for productive use in a trade or business. A 1031 exchange usually comes into play in one of these situations:

• Your company or its owners are selling a building they already use and buying a larger or better located one.
• The owners are selling an investment property and want to move into a building the company will use.
• A company is selling surplus land or a second facility and consolidating into one building.

If you are a tenant with no real estate to sell, a 1031 exchange usually does not fit, because you generally have nothing to exchange. A sale of your company does not automatically qualify either. Publication 544 says an exchange of the assets of a business for those of a similar business counts only to the extent it includes like-kind real property. Machinery, equipment and intangible assets generally do not qualify for exchanges after 2017, according to the IRS tax tips page.

The real property test is broad. The IRS says properties are like-kind if they are of the same nature or character, even if they differ in grade or quality, and that real properties generally are like-kind whether improved or unimproved. Real property in the United States is not like-kind to real property outside the United States. An exchange of property held primarily for sale does not qualify, and neither does real property used for personal purposes, such as your home.

Buying a building usually brings furniture, fixtures and equipment along with it. Those items may need to be analyzed separately. The Form 8824 instructions discuss personal property that is incidental to replacement real property, including a limit tied to 15% of the value of the replacement real property. Your CPA and intermediary should review any such purchase before it is included.

These two limits drive the whole process. In a deferred exchange the two periods both run from the date you transfer the property you are giving up.

• 45 days: the Form 8824 instructions say the replacement property must be identified within 45 days after the property being given up is transferred. Publication 544 calls this the identification period.
• 180 days or your return date: the replacement property must be received by the earlier of the 180th day after the transfer or the due date, including extensions, of your tax return for the year of the transfer.

The second limit can matter. If you transfer late in your tax year, your return due date could arrive before day 180 unless extended, so ask your CPA whether you need an extension.

Identification must be done correctly. Publication 544 says to identify replacement property in a signed written document delivered to the person obligated to transfer it or to another person involved in the exchange, other than you or a disqualified person, with a clear description, such as a legal description or street address for real property.

You can name more than one candidate, which is sensible given how often a purchase falls through. The publication's maximum is three properties regardless of fair market value, or any number whose total fair market value is not more than double the total fair market value of what you give up. A further rule applies if you identify too many, involving receipt of at least 95% of the identified value. Ask your intermediary to confirm your count.

A 45-day clock is short for an owner-user with specific space and power needs. Start your search, with backups, before you sell the property you are giving up.

You generally cannot hold the sale proceeds yourself. An IRS fact sheet from 2008, now marked as archival, warns that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction and make all gain immediately taxable. It describes using a qualified intermediary or other exchange facilitator to hold the proceeds. Publication 544 says a qualified intermediary enters into a written exchange agreement with you and, as required by that agreement, acquires and transfers the property you give up and the replacement property.

Choose carefully. The Form 8824 instructions say related parties and agents of the taxpayer are not eligible to be qualified intermediaries, and Publication 544 describes these as disqualified persons, including your agent at the time of the transaction. The archived fact sheet gives examples, such as your real estate agent or broker, accountant, attorney or employee, and also warns that some intermediaries have gone bankrupt or failed to meet their obligations. That means TAG, as your broker, cannot be your intermediary. Ask your attorney or CPA how to evaluate one, and ask how funds will be held.

Deferral has a cost that owner-users should model. Keep in mind these points from the IRS materials:

• Cash or other property received can be taxable. The IRS tax tips page says if you also receive other property or money, you must recognize gain to the extent of it.
• Basis carries over. Publication 946 says property received in a nontaxable exchange generally takes the adjusted basis of what you gave up, with special rules, and the archived fact sheet notes the depreciable basis is generally lower than in a taxable purchase. That can mean smaller depreciation deductions on your new building.
• Gain is deferred, not forgiven. The same fact sheet says that when the replacement property is sold outside another exchange, the deferred gain plus any new gain is subject to tax.
• Related parties have special rules. The Form 8824 instructions describe limits on exchanges with related parties, including a two-year rule on later dispositions.
• It has to be reported. You file Form 8824 with your return for the year of the exchange.

If the building you want must be bought before you can sell, ask about a reverse exchange. The Form 8824 instructions describe qualified exchange accommodation arrangements, and the archived fact sheet says the property can be parked with an accommodation titleholder for no more than 180 days. These are more complex, and financing the purchase can be its own question for your lender.

Tenant Advisory Group represents occupiers on the purchase side, so we can start your replacement search and keep a backup list ready for your identification deadline. The tax and exchange decisions belong to your CPA, attorney and intermediary.

1. Before listing your current property, ask your CPA to estimate the gain, the tax and the depreciation lost through carryover basis. Compare that with a plain sale and purchase.
2. Confirm who holds title to the property you are selling, and who will take title to the new one. Ask whether the same taxpayer needs to hold both, since Publication 544 speaks of property held by you.
3. Engage a qualified intermediary before the sale closes, and have the exchange language reviewed for your sale contract.
4. Build a shortlist of replacement buildings, with at least one backup, before you close the sale.
5. Calendar the 45-day date and the earlier of day 180 or your return due date, as of the actual closing date.
6. Line up financing that can close within the exchange period, and ask your lender how the exchange affects the down payment.
7. File Form 8824 with your return, and keep the exchange records.