A 1031 exchange isn’t just for a solo investor seeking to defer capital gains taxes on the sale of a commercial investment property.
The Internal Revenue Service allows like-kind exchanges for any taxpaying entity that wants to exchange one investment property for another, including S corporations, C corps, partnerships, LLCs, and trusts. There are some important rules and restrictions to the exchange process, however, and those restrictions can become even more complicated when multiple shareholders are involved.
Completing a 1031 Exchange For an S Corporation
An S corp with real property assets is free to sell those holdings at any time. However, if any assets have realized significant appreciation over time, the corporation’s shareholders will have to pay capital gains taxes, as well as any depreciation claimed during the time the asset was held according to their pro rata shares in the organization.
An S Corp can defer those tax liabilities by completing a 1031 exchange. The simplest type of exchange is a simultaneous exchange, where one property is exchanged concurrently for a like-kind asset of equal or greater value. The process is a straightforward exchange if the S corp plans to hold the replacement property as a business investment, but complications can arise if the corporation is dissolved or shareholders decide the time has come to take different financial paths. These opposing goals could create major hurdles that could potentially leave shareholders on the hook for hefty tax liabilities.
Here’s an example: If an S corp realizes gain from the sale of a real property asset, it must allocate that gain to shareholders according to their pro rata interests in the corporation. Each shareholder is subject to capital gains taxes on those proceeds. Even if one shareholder wants to complete a 1031 exchange with his or her share of the proceeds and other partners want to cash out, the exchanger still is subject to recognized gain according to his or her pro rata shares.
There are some scenarios where shareholders of an S corp can complete a 1031 exchange on legacy assets, but that requires owning and operating the asset as an active business investment -- likely the exact opposite scenario when dissolution of the corporation is the main objective or when shareholders are at loggerheads due to competing financial interests.
The Bottom Line
Business partnerships frequently dissolve due to retirement, dissatisfaction, operational disputes, and other key factors. S corps that own real property and are considering exchanging it as part of a change of ownership or dissolution could trigger a taxable event for all shareholders since S corporations are taxed differently than LLCs or partnerships upon breakup.
Cash-outs, breakups, and major ownership changes within an S corp often bring about some intricate legal and financial twists that require extensive consultation with tax professionals to unravel for the benefit of all. Any S corp considering selling legacy real estate and exchanging into a replacement asset should carefully weigh the pros and cons, as well as the long-term future of the corporation, to ensure shareholders don’t have dissimilar views on holding times and disposition of real property assets.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.