We have received a number of inquiries regarding commercial property held for use in a business and the preferential tax treatment of Internal Revenue Code, Section 1031. The calls were from owners that have sold their businesses then leased the facilities to the new business owner and business property owners looking at an exit strategy and wanting to use the 1030 Exchange to defer paying taxes. They have been told by professional contacts the potential of saving from federal and state taxes can account for thirty to forty percent of the value of the property being sold. By executing like-kind property, per IRC Section 1031, they can leverage the tax saving into a larger property or bigger return on investment.
Although the tax saving of a 1030 Exchange is a major incentive, there are risks associated with any property exchange. There have been changes in the business environment in the last several years that have impacted the various types of property being marketed. Given the current economic conditions it is a buyer’s market that tends to impact the terms and conditions of sale.
This is not a situation where one size fits all property used in a business. Not all types of investment or business used property are in high demand. Commercial property used in manufacturing or special use situations, where environmental issues or permits are required are more difficult to sell.
The main reason property owners were looking at a 1030 Exchange was associated with the tax saving. It should be noted that a 1030 Exchange does not avoid taxes but delays paying them. In addition, the transaction is more complex with rules that can cause certain taxes to be paid at the time of closing if like-kind property requirements are not met.
Although the tax implication is an important aspect of any buy or sell decision, it should not be only the factor involved in the decision making process. In most situations involving taxes and assets there is a number of options. Those options should evaluate the risk as well as the economic benefit. It is a return on investment vs. asset risk, not just a deferment of taxes.
The 1030 transaction has a number rules and conditions that may or may not fit the seller’s current requirements.
1) All funds received from the property being sold must be used to acquire like-kind replacement property’
2) The purchase price for the replacement property must be equal to or greater than the net sales price of the property that was sold.
3) The property to be received in the exchange must be specifically identified within 45 days of closing on the relinquished property.
4) The exchange period begins on the date the property is transferred and ends on the date that is the earlier of 180 days after the date of the transfer or the due date of the relinquishing party’s income tax return for the taxable year.
5) Replacement Property can be identified by one of the following three rules:
a) Three-Property Rule- any three properties regardless of their market values.
b) 200% Rule- Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate fair market value of all of the exchanged properties as of the initial transfer date.
c) 95% Rule- Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate fair market value of all the potential replacement properties identified.
There is also a requirement in Internal Revenue Code, Section 1031 that defines boot, that is, “any item in the trade that is not of the “like kind” as defined under Section 1031 of the IRS tax code”. If you cannot eliminate boot or as least minimize it, the 1030 Exchange may not be the best option. Cash or a promissory note is considered boot and is not included in the like-kind property, as such the income, is subject to capital gain taxes.
Normally, there are several options available to a business or trade property. Each is dependent on the current and future requirements of the seller. For example, age and financial condition of the seller may be important considerations as well as any asset risk or return on investment (ROI). It is always in the best interest of the seller to look at the options that are available as well as history of the property being sold to insure that there are no surprises that would impact the transaction upon closing.
The other options available to the seller:
1) Do nothing, keep the existing lease in place.
It is important to look at the terms of the lease. Is it a gross lease, NNN lease, are there increases in rental rates, and is there an option to purchase the property by lessee. The terms of the lease will have an impact on the ability to sell and the price a buyer will pay for the property. Are you looking at an exit strategy and will you use the property as way of getting a higher price for the business? Giving more favorable conditions to the lessee, that is, a rate less than area comparable commercial lease rates will result in a reduction in value of the property.
2) Sell the property and pay the capital gains tax. Given the changes in the tax code for 2013 this may be a viable option to a seller especially if they prefer to be in a cash position rather than have real estate.
3) Sell the property, owner financing, with 25% to 30% down payment, normally 30-year amortization with a 15-year term at five to 6 percent interest. Installment basis defers capital gains, note is secured by sellers property, seller monthly payment larger than rental, no additional requirements maintenance issues.
The process of buying, selling or exchanging property has changed, taxes are a major concern but being in a cash position seems to be the motivating force among a growing number prospects given the current economic environment.