When you sell a business or investment property for a profit, you generally owe taxes at the time of the sale. There is no exemption amount similar to the sale of a homestead.
However, there is a way to defer the tax bill. You can reinvest the proceeds from the sale into a similar property or use them as part of a qualifying like-kind exchange. These transactions are often referred to as 1031 exchanges, because the exception is contained in Section 1031 of the Internal Revenue Code.
Who can use a 1031 exchange and how does it work?
Anyone – individuals, corporations, partnerships, limited liability companies and trusts – who owns investment or business property can qualify.
The simplest example of a 1031 exchange is a simultaneous swap of two properties. Deferred exchanges are more complicated and allow transactions to include multiple properties, but the rules become very complicated.
FTB audits and noncompliance
The California Franchise Tax Board closely scrutinizes these transactions so it is imperative to work with an experienced tax professional. Audits often focus on these areas:
- Was the gain computed properly, for example were non-exchange expense items included?
- Did the exchange include a substantially similar property? Was a partial interest used to acquire a larger percentage interest?
- Was cash withdrawn from proceeds on the relinquished property?
If done incorrectly, an FTB audit related to a 1031 exchange can result in back taxes, penalties and fines.
To make matters more complicated the FTB and IRS do not always take consistent positions. A recent decision from the California State Board of Equalization involving swap and drop situations does bring California more in line with the approach taken by the IRS and federal courts, however.
The moral of this post is: obtain the assistance of an experienced tax attorney who can review a deal before you get into trouble.
Source: IRS.com, “Like-Kind Exchanges Under IRC Code Section 1031”