How to Initiate a 1031 Exchange

If you want to defer your capital gains tax, a 1031 exchange can be a way to do this while purchasing new property. There are several steps to follow if you want to initiate a 1031 exchange.

First of all, you should have real estate that qualifies for the exchange. Investment real estate or real estate that your business owns both qualify for 1031 exchanges. It’s a good idea to consult with an accountant before engaging in the process so that you are sure that you are exchanging appropriate properties.

Next, you need to find a buyer and a qualified intermediary. Don’t make the mistake of focusing on only finding a buyer. As soon as you find someone to buy, you need to have the intermediary lined up to accept the funds on your behalf or you could lose out on the benefits of the 1031 exchange. Once you have identified a buyer, draft a purchase and sale agreement. It’s important to inform the buyer that this is a 1031 exchange, and you should have your documents reviewed by an attorney to ensure that the terms of the sale are clear, as you would with any real estate transaction.

Your next step is to find a closing company that is familiar with 1031 exchanges. Following this, you should schedule a time to meet with your qualified intermediary. Hopefully, you have already done your research and selected an intermediary with integrity early on. Make sure you’re clear of the deadlines that you must follow in order to have the transaction classified as a 1031 exchange. You have 45 days to identify your replacement properties. You also have 180 days in which to close on the replacement properties.

Your final step is to close on the replacement properties. This is why consulting with your accountant and real estate lawyer, in conjunction with choose an experienced qualified intermediary, are so important. It can be easy to miss small details that could put the classification of your transaction as a 1031 exchange in jeopardy. Being clear from the outset and working with a team of professionals to benefit from a smooth transaction can have numerous benefits for you. The process is made much easier when you know what to expect and when you are guided through the process to adhere to deadlines. When done properly, a 1031 exchange can be essential for helping you defer the capital gains on your transaction.

Save Taxes When Selling a Dental Practice With a Section 1031 Exchange

A dental practice is sold for a variety of reasons: retirement, moving to another city, or even because of health issues. Regardless of the reason, it is critical to consider the tax ramifications of the sale. Depending on the type of assets sold, the seller can pay federal and state taxes of up to 40% of the gain. For example, a majority, if not the entire amount of the equipment sold is likely to be taxable at the highest rates for both individual and corporate owners. This is because most dental equipment is written off in the year of purchase or depreciated over a 5 to 7 year period. Therefore, there is usually a minimal amount of basis in the equipment at the time of sale.

If a corporation owns real estate, the gain is taxed at the highest corporate rate. If an individual owns the real estate and leases it to the corporation or other legal entity, the tax on prior depreciation is 25% and the gain in excess of depreciation is 20%. Goodwill, patient records, and accounts receivable are also assets usually included in the sale of a dental practice and will be taxed at the 20% rate. Needless to say, the tax liability can be substantial resulting from an outright sale.

Example of an outright sale of a practice and resulting tax liability::

Equipment: $120,000 gain X 40% tax rate = $48,000

Receivables: $ 20,000 gain X 20% tax rate = $ 4.000

Records: $ 90,000 gain X 20% tax rate = $18,000

Real Estate $250,000 gain X 20% tax rate = $50,000

Goodwill $115,000 gain X 40% tax rate = $46,000

As you can see, the total tax liability of $166,000 on this hypothetical sale is staggering, but there is a way to defer these taxes until well into the future. It is called a Section 1031 tax free exchange.

Deferring taxes through a tax-free exchange

Section 1031 of the Internal Revenue Code has been in existence since the early part of the 20th century. If you purchase “like-kind” property within six months of the sale of the practice, your taxes will be deferred, as long as the various rules are satisfied. There are two time periods involved. The first one, called the identification period, requires the selling dentist to identify one to three replacement properties within 45 days. The second period involves the actual purchase of the property. That needs to occur within 6 months after the sale of the practice.

Exchanges can be either total or partially tax-free. If you have sold your practice and are purchasing another one, it would qualify as a total exchange if you are purchasing a more expensive practice. If it is less than the sold assets, you it would result in a partial exchange and some taxes would be due. Another example of a partial exchange is one in which a practice is sold which includes real estate and the dentist subsequently purchases an apartment building for income property. If the building cost was greater than the real estate sold, no taxes would be due on that portion. Taxes would be due on the other assets sold.

Section 1031 tax-free exchanges are a great way to defer or in some cases eliminate tax liability. It is very important to follow the rules to the letter. Therefore, it is advisable to seek the guidance of an experienced attorney and/or CPA before implementation.

Kent Harlan has been a CPA since 1984 and has provided consulting, accounting and financial services to several industries. He is the owner of Ozarks Capital Funding, LLC, a financial services firm.