1031 Exchange for an Office Building

An office you occupy for your own practice qualifies without a single outside tenant

Reg. §1.1031(a)-1 covers real property held for productive use in a trade or business as well as property held for investment, so a dentist's office condo or a 20,000-square-foot building the owner's company fills is exchangeable on the same footing as a leased building. The property must not be held primarily for sale, and the same taxpayer that holds title must acquire the replacement; if the building sits in a separate real-estate LLC while the practice is a professional corporation, the LLC is the exchanger.

The replacement can be occupied by your business too; nothing requires a change from owner-use to landlord-use. Most owner-users exchanging at retirement want the opposite, though: property someone else runs.

Selling the practice with the building: only the real estate rides through the intermediary

When a group of assets that makes up a trade or business changes hands, §1060 requires the residual method and both buyer and seller file Form 8594 with the same allocation across seven classes: cash, marketable securities, receivables, inventory, Class V (buildings, land, furniture, fixtures, equipment), Class VI (§197 intangibles other than goodwill) and Class VII (goodwill and going-concern value). Only the land, building and structural components within Class V can be relinquished property; the regulations say goodwill is never like-kind, and since 2017 nothing but real property qualifies anyway.

Hypothetical $3,000,000 sale of a medical practice and its building: $2,100,000 to land and building (exchangeable), $150,000 to furniture and equipment (§1245 recapture, ordinary income), $50,000 to receivables and $700,000 to goodwill (taxable in the year of sale). Only $2,100,000, less the mortgage payoff, reaches the qualified intermediary, and the exchange agreement and the asset purchase agreement should be drafted as two coordinated closings with the allocation written into both.

Buyers push value toward equipment and goodwill for faster write-offs; you want it in the building. Settle the split before signing, because a Form 8594 you both file is hard to revisit.

Furniture, phone systems and cost-segregated components: the 15% rule and the boot it leaves

TD 9935's example is the exact scenario: a taxpayer exchanges into a $1,000,000 office building and takes $100,000 of office furniture that customarily conveys with it. The furniture is incidental for identification because it is under 15% of the real property's value, yet the taxpayer recognizes $100,000 of gain, the lesser of the $700,000 realized gain and the personal property received.

Cost-segregation studies complicate the sale side. Items reclassified as 5-, 7- or 15-year property may still be structural components or land improvements that Reg. §1.1031(a)-3 classifies as real property, and the regulation itself says a structure can be §1245 property for depreciation while remaining real property for §1031; §1245 recapture in an exchange is then limited to gain actually recognized under Reg. §1.1245-4(d). True personal property, such as furniture and freestanding equipment, cannot be exchanged and should carry its own line in the contract.

Recapture on a 39-year building is the largest number in the deal

Nonresidential real property is depreciated straight-line over 39 years, and every dollar of that depreciation comes back as unrecaptured §1250 gain taxed at up to 25% when you sell, ahead of the 15% or 20% rate on the rest and the 3.8% net investment income tax where it applies. A fully deferred exchange carries the recapture into the replacement; it does not disappear.

Hypothetical: a building bought 15 years ago for $1,500,000 ($1,200,000 allocated to the structure) has taken about $460,000 of depreciation and sells for $2,500,000. Adjusted basis is roughly $1,040,000 and gain about $1,460,000: $460,000 at 25% is $115,000, $1,000,000 at 20% is $200,000, and 3.8% on the whole gain adds about $55,000, roughly $370,000 of federal tax before state tax. An exchange that reinvests the full $2,500,000 defers all of it.

Sale-leaseback or straight sale, and why a related-party buyer changes the rules

A sale-leaseback to an unrelated investor is a sale plus a new lease: your company signs a long net lease, the investor prices the building on that rent and your credit, and the sale itself can be relinquished property in an exchange. A straight sale of a vacant or owner-occupied building is priced on comparable sales instead, which usually matters more to the check size than to the tax rules.

Selling to an entity you, your spouse, siblings, parents or children control brings §1031(f) into play: if either side disposes of its property within two years of the last transfer, the deferral is lost, and Form 8824 must be filed for the two following years to track it. Rev. Rul. 2002-83 goes further, denying deferral where a related party ends up with cash through a qualified intermediary, so a structure in which a family LLC buys the building while you exchange elsewhere needs counsel on both sides.

Have your attorney and CPA vet any transaction that touches a related entity before the contract is signed.

Passive replacements for an owner-user: net leases, DSTs, multifamily and 30-year ground leases

A lease with 30 years or more to run, including renewal options, is like-kind to a fee interest, so a ground lease under a net-leased building is an eligible target; shorter leaseholds are real property under the 2020 regulations but are not treated as like-kind to a fee. Single-tenant net leases, medical office and multifamily DSTs qualify under Rev. Rul. 2004-86, and a cash-out DST can absorb a large mortgage payoff you would otherwise have to re-borrow.

The 45-day identification and 180-day closing periods run from the building's closing, not the practice sale, so if the buyer wants the business first and the real estate later, the exchange clock does not start until the deed transfers.

Vacancy, remaining lease term and tenant-improvement obligations set the equity you must replace

A multi-tenant building with two years left on its main lease, or with free-rent and TI commitments the buyer will credit at closing, nets less cash, and less cash means a smaller replacement can be bought without boot. Full deferral needs a replacement of equal or greater value and the mortgage you pay off replaced with new debt or cash, since Publication 544 treats liabilities the buyer assumes as money received.

Exchange funds can pay for improvements only while an exchange accommodation titleholder holds the replacement; Publication 544 states that production after you receive the property is a taxable exchange of property for services. Budget renovations from other money or set up an improvement exchange from the start.