If you own your property and your business is growing quickly, it may be tempting to cash out and move to a bigger or better location -- except for the capital-gains tax. So it's no surprise that so-called 1031 Exchanges, which let business owners defer that tax, are gaining in popularity. San Francisco's Investment Property Exchange Services (FNF ), one of the largest facilitators of 1031 Exchanges, worked on 23,000 such deals in 2004, up 40% from 2003.
A 1031 Exchange, also called a Starker Exchange, allows business owners to defer capital-gains taxes by exchanging a property for one of "like kind." That generally means real estate of equivalent or higher value. "The exchanges allow investors to reinvest all of their equity, including that which they would have paid in taxes, into real estate," says Christian Mirner, executive vice-president at consultants 1031 Exchange Options in Walnut Creek, Calif. The property must be used for a productive business or investment. In January, the Internal Revenue Service began approving 1031 Exchanges for home offices.
Skysite Associates, a New York commercial and residential property manager, has done four exchanges in as many years, upgrading the properties in its investment portfolio. "It's great for a small business if they own their own building and are growing out of it," says John Colangelo Jr., president of the $3 million, five-employee company. The exchanges have allowed Skysite to defer a total of $3 million in taxes.
You'll have to obey some complex rules to follow in Skysite's footsteps. A disinterested third party -- preferably a qualified intermediary that specializes in 1031s -- must handle the transaction. (Find a list on 1031.org.) The intermediary will hold proceeds from the sale of your current property in a fund similar to an escrow account, and usually charges between $500 and $2,000 for the service. You'll then have 45 days to identify in writing the property you'd like to buy, and 180 days to complete the deal.
There are a few situations in which 1031s are not such a good idea. "If a taxpayer has losses to offset gains on a sale, [he is] better off selling a property using those losses," says Lawrence Israeloff, director of taxation at Feldman Meinberg & Co., a Syosset (N.Y.) accounting firm. And if you eventually sell the property without using the 1031 provision, you'll pay capital gains on the difference between the purchase price of your first property and the sale price of the last. Eventually, the tax man gets paid.
By Jeremy Quittner