How 1031 Can Help Small Businesses Grow

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 Section 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 for small business owners

IRC Section 1031 allows for the deferral of capital gains taxes, depreciation recapture, and certain other taxes on the sale of real property when the seller purchases a like-kind property within 180 days or the filing date of the taxpayer’s tax return as well as meeting certain requirements.

One of the most important aspects of Section 1031 is that it only applies to property “held for productive use in a trade or business or for investment.” This means that your primary residence won’t qualify (there is another section of the tax code for that).

If you operate a small business out of your home, it’s possible that the portion of the property used for business could qualify for 1031 treatment, but each case is unique. For those who operate out of a retail storefront, office space, warehouse, or another property type that isn’t also a home, establishing qualifying business use is much cleaner.

Do I have to exchange for another property of the same type?

Another important 1031 rule is that your replacement property (the property you’re acquiring in your exchange) must be “of like kind” to your relinquished property (the property you’re selling in your exchange.

The definition of “like kind” is quite broad, and simply means any real property used for business or investment purposes. This can include factories, office buildings, or restaurants, as well as residential real estate, and any of these can be exchanged for one another. A 1031 exchange can help business owners switch industries, relocate to better position themselves for success, or expand faster thanks to the ability to reinvest more of the sales proceeds from the relinquished property sale.

If some of this terminology seems confusing, check out our guide to key 1031 terms.

The benefits of owning your space: building wealth through 1031 exchanges

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 through 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.”

Given profit margins in the restaurant industry, it’s entirely possible that the gain from your real estate could eclipse your sales, and thanks to Section 1031, you can use that equity 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, even to another city or state.

In the case of a restaurant or retail business, if you are considering relocating, the new location may be more expensive than where you are currently located. By deferring your capital gains taxes with a 1031 exchange, you will have access to more funds to invest in a more desirable location. If your business is expanding and you need a larger warehouse or manufacturing space, Section 1031 makes it possible to upgrade without immediate tax payments slowing down your growth.

You could also use the sales proceeds to open multiple locations, or diversify into properties for different kinds of businesses: clothing stores, apartment buildings, farmland, etc. By performing a like-kind exchange, you’ll have more capital to invest and won’t be limited to just one industry.

When it’s time to sell or close your business: 1031 and retirement

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, Section 1031 can again be beneficial. Because of the definition of like kind, you won’t have to perform a taxable sale, or be limited to reinvesting in the same type of business. You can pivot, expand your portfolio, and continue deferring taxes even after the main venture has run its course.

When you retire, you can exchange into more passive investments like Delaware Statutory Trusts or triple-net lease properties. This flexibility, and the ability to perform subsequent exchanges, is why 1031 has become such a popular retirement strategy for savvy investors. And when it’s time to think about estate planning, 1031 exchanges and DSTs can help simplify the process.

How to get started with your first 1031 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 sales proceeds must be held by a Qualified Intermediary (QI).

In addition to a standard forward exchange, there are many other types of exchanges, including reverse exchanges, international exchanges, improvement exchanges, and more. Before selling your relinquished property, it’s important to understand your options and work with a QI that has experience with the type of exchange you’re looking to perform.

JTC’s team has decades of 1031 experience, and we provide the same service to first-time exchangers that we do for our corporate and DST clients, including our online platform that provides 24/7 access to exchange information from anywhere in the world. With unmatched in-house expertise, we can handle complicated exchange scenarios that others 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.