Selling a business or investment property is a big decision with many financial ramifications. Sure you’re likely to gain some profit, but you’re also likely to be hit with a significant tax liability on any gains realized from your assets.
If you plan on disposing of real property or depreciable business property, you can potentially mitigate the tax burden generated from capital gains on these assets if you plan ahead. In this article, we’ll look at Section 1231 gains, which straddle a line between capital gain and standard income and are taxed at a more favorable rate. We’ll also discuss ways you can defer any capital gains entirely.
Section 1231 Gains Defined
In the simplest of terms, the IRS defines Section 1231 assets as depreciable assets or real property held by your business that you’ve had for more than a year. Of course, there are some caveats. For real property, it must be in use by the business or trade. Business assets that might qualify for Section 1231 gains include:
If any of these assets or the property was held for less than a year, they do not qualify for Section 1231 gains. Also, if any of these assets are sold for a loss, the loss does not receive any preferred treatment and is categorized as ordinary losses for accounting purposes.
Let’s take a hypothetical example and put it all together. Say you work as a chiropractor and you're nearing retirement. Business has been thriving, so much that a few years back you were able to purchase your own building. But now it’s time to take down your shingle and sell the business.
It might be easier to attract prospective buyers by offering the business and building together as a package deal, but if you opt for that route you’ll be liable for capital gains on both assets. An alternative course of action is to sell the chiropractor practice and building independently of each other so the building qualifies for a section 1231 gain rather than standard capital gain.
Utilizing the tax code as written can result in a lower tax liability -- and there are ways you can defer 100 percent of those capital gains if you are willing to reinvest sale proceeds back into real estate.
How to Defer Capital Gains: The 1031 exchange
A 1031 exchange is an investment tool that allows you to defer capital gains on the sale of an investment property by rolling the proceeds into a similar or “like-kind” asset. While you won’t be cashing out, you also won’t be paying the IRS a large chunk of your profits from Section 1231 capital gains taxes when you divest real property held by your business or practice.
There are a few important deadlines associated with 1031 exchanges, mainly 45-days to formally identify like-kind replacement assets and 180 days to close on the property. With that in mind, it’s important to initiate the exchange process prior to relinquishing an investment property to help ensure a successful exchange since those hard deadlines have no grace period.
A 1031 exchange can potentially provide recurring monthly income and asset appreciation, and there’s no limit to the number of times you can exchange into newer and progressively larger assets. However, if you sell a 1031 exchange property without completing another exchange, you’ll be liable for all deferred capital gains and depreciation recapture taxes. That’s why some real estate investors swap properties via 1031 exchange until they pass. If they bequeath their assets to their heirs, those parties receive a one-time step-up in basis that could effectively wipe out all those deferred tax liabilities.
This article is intended to be an overview of Section 1231 gains. It’s a complex topic, so be sure to discuss Section 1231 gains and 1031 exchanges with your certified tax professional and legal counsel to ensure you fully understand how both might impact your tax liabilities and investment goals.