By performing a like-kind exchange when relocating or expanding, you can invest more of your gains and allow your business to flourish. Most of what you’re likely to read about 1031 exchanges centers around rental properties such as single-family homes or multifamily apartment buildings. While it’s true that residential and large-scale commercial real estate are popular uses of 1031, it can also be a smart strategy for small business owners as they grow and eventually sell their businesses. Here’s how 1031 can help entrepreneurs to realize their business goals.
How 1031 exchanges work
Section 1031 allows for the deferral of capital gains taxes and depreciation recapture on the sale of real property provided the seller purchases a like-kind property within 180 days and meets certain requirements. The key for small business owners is this statement:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
“Like kind” simply means any real property used for business or investment purposes. This can include warehouses, office buildings, and retail spaces as well as residential real estate, and any of these can be exchanged for one another. Operating businesses can use 1031 to relocate to better position themselves for success. If you own the space where your business operates, 1031 can help you expand faster.
The benefits of owning your space
Because real estate is a consistent way to build wealth, if you own the site where you do business, you’ll be accruing wealth from the property as you try to do the same from your business. Depending on how property values grow over time, you could potentially gain more from the property than the business itself. This sentiment was echoed by former McDonald’s CFO Harry J. Sonneborn when he said, “we are not technically in the food business. We are in the real estate business.”
This is why fast food is incredibly popular with 1031 investors. Given profit margins in the restaurant industry, it’s entirely possible that the gain from your real estate could eclipse your sales, and you can use that capital to help your business. If you’re in a location that isn’t bringing in the revenue you want, you aren’t stuck there. You can use the increased value of the property to relocate.
In the case of a restaurant, if you are considering relocating, the new location may be more expensive than where you are currently located. By deferring your capital gains tax with a 1031 exchange, you will have access to more funds to invest in a more desirable property.
You could also use the sale proceeds to open multiple locations, or diversify into properties for different kinds of businesses: restaurants, clothing stores, apartment buildings, etc. By performing a like-kind exchange, you’ll have more capital to invest, and won’t be limited to just one industry.
Upgrading and expansion with 1031
Entrepreneurs can benefit greatly by starting small: in 2022, small-batch clothing manufacturing is poised to win big due to supply chain woes slowing down larger manufacturers. But while starting out small may be smart, you might need more space as you grow. Buying a warehouse requires capital, which is why many may rent to start out, but those who own their small warehouses may find it easier to upgrade.
The commercial real estate market is booming, and your property is likely worth a lot more than it was when you bought it, even if you’ve taken on debt to make the purchase. Rising construction costs mean existing structures are going up in value, which means you can get a lot for your property right now, but also that you’ll likely pay a lot for a larger warehouse. Instead of taking on even more debt, 1031 can help you make a larger down payment and get into a larger space with less risk.
When it’s time to sell your business
Eventually, the time may be right for you to part with your business venture. When it’s time to close up shop and sell your space, 1031 can again be beneficial. If you’re getting out of one industry and into another, you can use the proceeds from the sale of your site for the purchase of a different retail, warehouse, or office space. If you don’t plan to start another operating business, you can use the sale proceeds for real estate investments like multifamily housing.
And when you retire, you can perform a 1031 exchange into more passive investments like Delaware Statutory Trusts or triple-net lease properties. This flexibility, and the ability to perform multiple subsequent exchanges, is why 1031 has become such a popular retirement strategy for savvy investors.
How to get started with your first exchange
In order for your exchange to qualify under Section 1031, there are specific rules that must be followed. The replacement property must be identified within 45 days and purchased within 180 days, and the sale proceeds must be held by a Qualified Intermediary.
As the nation’s most trusted 1031 Exchange accommodator, JTC has more than 30 years’ experience as a QI, with tens of thousands of successful transactions. With unmatched in-house expertise and an award-winning cloud-based online platform, we can handle large and complicated exchange scenarios that most QI’s can’t. Whether you’re an entrepreneur looking to make your first exchange or a seasoned investor ready for retirement, JTC is here to help.
Learn more about 1031 Exchange services, by visiting the JTC 1031 Exchange Guide.