No, an operating business cannot be exchanged as a whole under Section 1031. Since January 1, 2018, 1031 exchanges generally apply only to qualifying real property held for investment or productive use in a trade or business. However, if you are selling a business that also owns commercial real estate, the real estate portion of the transaction may qualify for a 1031 exchange.
Which Business Assets Qualify for a 1031 Exchange?
The IRS treats the different assets involved in a business sale separately. A 1031 exchange may allow you to defer gain on qualifying real property, but it does not automatically defer gain on the other assets being sold.
- Commercial real estate: Land, office buildings, warehouses, retail buildings, and other qualifying real property held for business or investment use may be eligible.
- Equipment and machinery: Generally ineligible because they are personal property rather than real property.
- Inventory: Does not qualify for Section 1031 treatment.
- Goodwill and business value: The value of customer relationships, brand recognition, and the operating business itself does not qualify.
- Business ownership interests: Corporate stock and partnership interests are not qualifying replacement real property.
Importantly, selling a restaurant and purchasing another restaurant does not automatically create a qualifying exchange. The question is whether qualifying real estate is being exchanged, not whether the businesses operate in the same industry.
Example of Selling a Business With Real Estate
Consider a hypothetical restaurant owner who sells the business and its building for $2.5 million. The purchase price is reasonably allocated among the assets as follows:
- Commercial building and land: $1,800,000
- Kitchen equipment and furnishings: $200,000
- Inventory: $100,000
- Goodwill and other business value: $400,000
Assuming the real estate satisfies Section 1031 requirements, the $1.8 million real estate component may potentially be exchanged for qualifying replacement real estate. The remaining $700,000 of business assets is not eligible for Section 1031 deferral.
This example describes the allocation of sales proceeds, not the taxable gain. The owner must work with a tax professional to determine adjusted basis, gain, depreciation recapture, purchase-price allocation, and the tax treatment of each asset. Full deferral of eligible real estate gain also depends on the exchange structure, reinvestment, debt, and any taxable boot.
What Should Business Owners Do Before Closing?
- Identify the real estate owner. The taxpayer disposing of the qualifying property generally must be the taxpayer acquiring the replacement property. Entity structure and tax classification can affect this requirement.
- Separate the assets. Work with your CPA and transaction attorney to establish and document a supportable purchase-price allocation among real estate and other business assets.
- Arrange the exchange before closing. For a deferred exchange, engage a qualified intermediary before the relinquished real estate closes so exchange proceeds can be handled properly.
- Follow the exchange deadlines. Generally, replacement real estate must be identified within 45 days and acquired within 180 days, or by the applicable tax-return due date, including extensions, if earlier.
- Confirm replacement property eligibility. Both the relinquished and replacement properties must satisfy the applicable real property and business or investment use requirements.
For the broader transaction, see our guide to selling a business and its real estate. You can also review the 1031 exchange rules and requirements before structuring the sale.
Can You Purchase Another Business With 1031 Exchange Proceeds?
Not as a qualifying replacement for the business itself. Buying stock, goodwill, inventory, equipment, or an operating company does not meet the real property requirement. However, qualifying real estate purchased as part of a business acquisition may potentially serve as replacement property if the ownership, allocation, use, and exchange requirements are satisfied.
The key distinction is between the operating business and its real estate. A properly structured exchange may defer eligible real estate gain, while the sale of the other business assets remains subject to separate tax rules.