1031 Strategies: For Selling Hotels, Businesses and Many Others
Most exchanges are performed on a delayed basis and involve the sale of real property. Using a 1031, you can dispose of business or investment property (relinquished property) and acquire qualified like-kind property (replacement property) without recognizing taxable gain. The gain merely is carried forward into the new property, and the tax due is deferred. In a “multi-asset exchange”, multiple tax components that are not like-kind can be successfully sold together – while still reaping the myriad benefits of a 1031 exchange.
The sale of business or investment property may also include personal property, such as appliances, computers, furniture, or equipment. In fact, most multi-asset exchange properties, including restaurants, hotels, convenience stores, television stations, and retail businesses where the owners are selling the underlying real estate, involve a substantial percentage of qualified personal property. Other examples include nursing homes, health care facilities, furnished rentals, and ranches. To avoid undesirable tax consequences when selling properties such as these, consider using a multi-asset exchange, in which like-kind personal property can be exchanged and taxes are deferred.
The Code defines qualified property as "property held for productive use in a trade or business or held for investment." The properties exchanged must also be "like-kind". All investment real estate is like-kind to any other type of investment real estate, but this is not so with personal property. The like-kind definition is much narrower and requires that items be in the same asset or product class. For example, although the Internal Revenue Service considers the land and buildings of a hospital and a restaurant like-kind for an exchange, the inventory, furniture, and fixtures are not necessarily like-kind. Thus, a bed in a hospital is not considered like-kind with a cash register in a hotel, even though both items are used in conjunction with a business.
For personal property to be like-kind, it must fall within the same classification. Thirteen general asset classes, defined in Treasury Regulations Section 1031(a)2, and numerous product classes set forth in the North American Industrial Classification System manual, categorize like-kind personal property.
It is usually best for the sales contract to separately list the value for the real estate and personal property. Ideally, a separate exchange agreement covering the personal property would include a complete inventory list broken down by classification with corresponding values. At closing, the personal property could be sold under a separate bill of sale.
Multi-asset exchange transactions may become complicated because the value allocations that are best for the seller are not always best for the buyer. Typically the seller and buyer negotiate on the values assigned to various components. Consider the following strategies to maximize your position.
Understand the various components of the property offered for sale and have an idea of the adjusted taxable basis of each. Enlist the aid of your accountant or your financial adviser who is knowledgeable about the property, the related tax situation, and multi-asset exchanges. You may wish to use an intermediary firm that routinely handles this particular type of transaction. By doing your homework, you will be prepared to maximize your position when contract negotiations begin.
Establish your priorities before negotiations begin. Minimize values assigned to non-qualifying components of the property, such as goodwill. The IRC does not recognize goodwill as qualified property in an exchange transaction. Consequently, any value assigned to goodwill in a relinquished property sale will fall outside of the exchange and be taxable. If the value of the real estate solely cannot substantiate the contract price, the remaining value is assigned to depreciable personal property and goodwill. How much value is assigned to each may vary. Any recapture-of-depreciation gain that results from not matching these components on personal property is taxed at the maximum federal rate of 35 percent. Though goodwill cannot be replaced, it is taxed at the lower capital gain rates.
Work backwards. As you are planning, it may be helpful to work “back from the future”. First, determine the type of replacement property you want to buy. If it contains different asset classes, complete a value allocation. Take this information and overlay it or use it as a guide to help you understand what values you need in the different categories on your relinquished sale to gain the most benefit. By going through this type of analysis, you can determine if your plan is sound, if you need to adjust your valuation or if you should consider a different type of replacement property that will give you a better match up.
Assign Values. In a successful transaction, the values of the various components of the relinquished and replacement properties should match as closely as possible. If the values of the replacement property components equal or exceed those of the relinquished property, the tax on the sale can be deferred. If the corresponding component values are less than those of the relinquished property, only a portion of the tax may be deferred, resulting in a partial exchange. Ask your tax professional to see if flexibility exists in the assignment of values in situations in which the components do not match, as you may wish to assign a supportable value that would be most beneficial to you.
Conversely, if you are the purchaser in a transaction, you may wish to assign greater value to the personal property with a faster depreciation schedule and less value to components that are depreciated more slowly (such as improvements) or to the non-depreciable components (such as land) in the transaction.
Look at the costs v. benefits. There may be instances in which the potential tax liability on the sale is not great enough to warrant consideration of a multi-asset exchange, which is more costly and complicated than a regular delayed exchange. It’s important to ask your tax adviser to provide information about the tax consequences of the potential sale to determine the gain on the personal property portion. It may be more cost-effective and efficient to simply complete an exchange on the real estate portion and pay any tax due on the sale of the personal property. However, if this is not the case, then this more sophisticated exchange may be a worthwhile strategy.
Successfully completing a multi-asset exchange that maximizes the benefits to you requires a variety of skills, knowledge, and preparation. Knowing the right questions to ask is vital to developing a contract strategy. A real estate, accounting or tax professional who is knowledgeable about the many facets of multi-asset exchanges is an invaluable resource when considering this exchange option.