A 1031 exchange is commonly used for real estate investment transactions, but can also be used for buying a business.
Investing in a business can be costly when considering the tax implications. That is why a 1031 exchange is appealing when you want to buy a business with the funds from selling an investment property. In a 1031 exchange, you can defer the payment of capital gains taxes on the sale of a property or business when replacing it with a like-kind investment.
The property you are selling in the exchange must be a like-kind investment to the business you are purchasing. A like-kind property must be equal or lesser value of the relinquished investment.
It is easiest to invest in a similar business, but it is possible to exchange a different type of property, like a rental property, into purchasing a business. For example, selling a duplex and replacing it with a commercial property or relinquishing farmland and investing the funds into a storefront.
The exchange must be on like-kind properties or businesses within the United States. Also, when investing in a business with a 1031 exchange, you cannot use the exchange funds for things like inventory.
You can also use a 1031 exchange for the sale and purchase of a specific category of business, like a franchise or chain of stores. For example, you can do an exchange on a franchise in one market for one in another market. Or, a similar business can replace a national business, like a national car dealership chain for another car dealership chain.
In any like-kind 1031 exchange, a Form 8824 must be completed with the IRS. You file the form with your federal tax returns in the year that the original investment is relinquished.
When completing a 1031 exchange, the steps are generally the same, whether you are buying real estate or a business.
Obviously, this is a high-level overview of the steps, but gives you an idea of the general process of buying a business with a 1031 exchange.
The IRS provides more details on buying a business with a 1031 exchange in IRS Publication 544.