If I sell a business with its building, can I exchange only the real estate?

Section 1031 reaches only the real property inside the business

Since 2018, section 1031(a)(1) applies only to real property held for use in a trade or business or for investment. Reg. section 1.1031(a)-3 defines that as land, inherently permanent structures and their structural components, plus some intangibles such as leaseholds and easements. Machinery integrated into a building can count; Example 5 treats a 12-ton printer installed during construction as a structural component.

The same regulation draws the line on business rights. Example 12 holds that a license to operate a business in a building 'is not real property or an interest in real property', even when it cannot leave that building. Stock and partnership interests are excluded outright, so selling the shares of the company that owns the building is not an exchange of real estate at all.

One caution on classification: the regulation's definition applies 'only for purposes of section 1031'. An item that is real property for the exchange can still be section 1245 property whose depreciation is recaptured as ordinary income.

The price is split by the residual method, and a written allocation binds both sides

Section 1060 requires the buyer and seller of a group of assets that makes up a trade or business to allocate the consideration among the assets the way section 338(b)(5) does. The Form 8594 instructions list the classes: cash in Class I, securities in II, receivables in III, inventory in IV, then Class V, which generally holds furniture, fixtures, buildings, land, vehicles and equipment, then Class VI intangibles, and finally goodwill and going concern value in Class VII. Each class up to VI is capped at fair market value; goodwill takes the residue.

Section 1060(a) adds that if the parties 'agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both' unless the IRS determines it is not appropriate. The buyer usually prefers more on equipment for faster depreciation; you prefer more on the real estate you will exchange. Settle it in the purchase agreement, not at tax time.

The exchange and the allocation fit together by design. The instructions say Form 8594 is not filed for assets exchanged under section 1031, but 'if section 1031 does not apply to all the assets transferred, however, Form 8594 is required for the part of the group of assets to which section 1031 does not apply', citing Reg. section 1.1060-1(b)(8).

Worked example: a $3,000,000 sale where $1,800,000 is real estate

Hypothetical, round figures, no debt, state tax ignored; run your own numbers with your CPA. The agreed allocation is $1,800,000 to land and building with an adjusted basis of $700,000, $300,000 to equipment with an adjusted basis of $50,000 after $450,000 of depreciation, $100,000 to inventory at its cost, and the $800,000 residue to goodwill you built yourself with no basis.

The real estate carries $1,100,000 of gain. If the full $1,800,000 goes to the intermediary and buys replacement real property of at least that value, that gain is deferred and reported on Form 8824.

Everything else is taxed in the year of sale. Under the rule in Publication 544, equipment gain is ordinary income up to the lesser of the depreciation taken or the gain, so all $250,000 is ordinary. Inventory sold at cost produces no gain, and goodwill produces $800,000 of gain. Roughly $1,050,000 is recognized now and $1,100,000 is deferred.

• Real estate: $1,800,000 price, $700,000 basis, $1,100,000 gain deferred through the exchange.
• Equipment: $300,000 price, $50,000 basis, $250,000 ordinary income under section 1245.
• Inventory: $100,000 price at cost, no gain.
• Goodwill: $800,000 residual, zero basis, $800,000 gain.

Close both pieces together and keep the money streams apart

A single purchase agreement can cover the whole business if it allocates the price and assigns only the real estate portion to the intermediary; two coordinated contracts, one for the real estate and one for the business assets, make the separation clearer. Either way, the settlement statement should show the real estate proceeds wired to the intermediary and the business proceeds paid to you.

The 45-day and 180-day periods run from the date the real estate transfers. If the business assets close first and the building later, for example after a lease period, your exchange clock starts with the building, not the business.

Watch the seller who owns the building personally and runs the business through a company. The taxpayer who held the real estate is the one who must exchange it, which matters for title on the replacement; see the same-taxpayer rule.

Where the real estate proceeds can go once you stop operating

The deferred share can buy any real property held for business or investment, including a single-tenant building, land, or interests in a Delaware statutory trust of the kind Rev. Rul. 2004-86 treats as eligible replacement property. Owners leaving day-to-day operations often look at these; the planning is in from business owner to passive investor and exchanging an owner-occupied building.

The taxable share cannot be sheltered by the exchange. Capital gain within it can, however, be invested in a qualified opportunity fund within 180 days under section 1400Z-2; see opportunity zone funds.