Many changes in the new tax law require Oklahoma Small Businesses to revisit their planning. One of the under utilized provisions of the tax code provides a powerful tax planning strategy, but now there are new restrictions.
IRC Section 1031 allows certain transactions to not be taxes, potentially permanently. Otherwise known as “Like-Kind Exchanges”, these transactions allow businesses that are replacing property with similar property to defer tax with the proper elections. Previous to the law change eligible property included business personal property and real estate. The new law now restricts this property to real estate. Still a great tax planning tool, but the planning must be done now!
Let’s say you have a building you bought 10 years ago for $500,000, and that you want to sell and purchase a “new” building. I use “new” to mean new to you, not necessarily new construction. When you purchase the “new” building in a 1031 transaction, you use the old building basis ($500k less depreciation) as the basis for the new property, and no gain is recognized. There are specific requirements to qualify for 1031 treatment, such as you can’t receive any cash back from the transaction. You can compound 1031 transactions indefinitely.
Where this tool becomes really powerful is if the taxpayer holds the property until death. The property then qualifies for a “step up in basis” to the value at the date of death. This means that the gain from the 1031 transaction is never taxed. That original building you bought for $500k could be worth $1mm at death, and the gain of $500k would never be taxed. Pretty powerful!
Several years ago, many companies started using cost-segregation to accelerate depreciation on real estate purchases. Items that had a shorter depreciation life, such as HVAC systems, were separated and depreciated quicker. These items, also known as business personal property, are no longer eligible for 1031 exchanges. So when a property is sold only the real estate portion is eligible for like-kind exchange. For some properties, the business personal property could be 25-30% of the total. All of this business personal property would be subject to capital gains.
Taxpayers need to revisit their tax planning now to avoid unintended consequences. Don’t wait!