You can use a 1031 exchange on the sale of a business, but only for the real estate portion of the deal. The IRS does not treat an operating business as one exchangeable asset. The land and buildings can be rolled into replacement real property and the gain deferred; equipment, inventory, goodwill, receivables, and covenants not to compete are taxable at closing. Every business-sale exchange is therefore a partial exchange, and the structure of the sale itself decides whether the deferral is available at all.
What Actually Qualifies
Since the Tax Cuts and Jobs Act took effect in 2018, Section 1031 is limited to real property held for productive use in a trade or business or for investment.1Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips In a business sale, that generally means the land, the building, permanent structures, and their structural components such as wiring, plumbing, and HVAC. Real property held primarily for sale, like a developer’s finished lots, is excluded.2Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
Everything else in the deal is out. Machinery, vehicles, office furniture, computers, and specialized tools are fully taxable dispositions. Intangibles carry the most weight in most successful businesses and none of them qualify: goodwill, trade names, proprietary technology, and customer lists all trigger immediate gain. Covenants not to compete produce ordinary income. Accounts receivable and inventory are ordinary income too. In many transactions these non-qualifying pieces make up the majority of the purchase price, so a seller who expected to defer tax on the whole business will be looking at a much narrower deferral than they thought.
Asset Sale vs. Entity Sale
The gating question is how the business changes hands. Only an asset sale keeps the exchange available. In an asset sale, each component of the business is transferred as a separate line item, so the real property can be pulled out and routed through a like-kind exchange while the rest closes as a taxable sale.
Selling ownership interests in the entity closes that door. Stock in a C-corporation or S-corporation is a security, and the statute explicitly excludes stocks, bonds, notes, and other securities from like-kind treatment.2Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment A partnership interest is treated as intangible personal property and is outside Section 1031 as well, no matter what real estate the partnership owns underneath.3Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 The same logic reaches a multi-member LLC taxed as a partnership: selling membership interests is a partnership interest sale, not a sale of the underlying real estate.
There is one clean exception. A single-member LLC is disregarded for federal income tax purposes, so when it sells its assets the IRS treats the transaction as if the sole owner sold them directly.4Internal Revenue Service. Single Member Limited Liability Companies The real property inside a single-member LLC is exchange-eligible without restructuring.
Structure has to be negotiated early. Buyers often prefer entity purchases because contracts, licenses, and permits can carry over more easily. If the buyer insists on buying the entity, the seller loses the exchange option on the whole deal.
Splitting the Purchase Price
Because only part of the sale qualifies, the purchase agreement has to assign a specific dollar amount to every asset changing hands: land, building, equipment, furniture, inventory, goodwill, covenant not to compete, and anything else on the list. That allocation determines how much of the deal is deferrable and how much is taxable now.
Buyer and seller do not want the same numbers. The seller usually wants more value assigned to the real property, where gain can be deferred, and less to ordinary-income items like a covenant not to compete. The buyer usually wants more allocated to depreciable assets to generate deductions going forward. Both sides file Form 8594 to report the allocation, and the IRS compares those filings.5Internal Revenue Service. Instructions for Form 8594 Inconsistent numbers between buyer and seller are one of the most reliable audit triggers in this kind of transaction, so the allocation needs to be settled before closing, not after.
Running the Exchange on the Real Property
Once the real property is carved out, the exchange itself follows the standard deferred-exchange rules.
Use a Qualified Intermediary
Only the sale proceeds allocated to the qualifying real property flow through a qualified intermediary, whose job is to keep the seller from having actual or constructive receipt of the cash. The proceeds allocated to everything else go directly to the seller at closing and are immediately taxable. Treasury regulations provide a safe harbor confirming that a qualified intermediary is not treated as the taxpayer’s agent for Section 1031 purposes.6eCFR. 26 CFR 1.1031(b)-2 – Safe Harbor for Qualified Intermediaries The intermediary has to be genuinely independent; the seller’s attorney, accountant, or real estate agent generally cannot serve, and neither can anyone who has been the seller’s employee or agent within the prior two years.
The 45-Day and 180-Day Deadlines
Two clocks start on the day the relinquished real property closes, and missing either one destroys the deferral.3Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 The seller has 45 calendar days to identify potential replacement properties in writing, signed and delivered to the qualified intermediary. The replacement property must then be acquired by the earlier of 180 calendar days after closing or the due date, with extensions, of the seller’s tax return for the year of the sale.2Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
That second clause catches sellers off guard on late-year deals. Close in October without filing a return extension and you may lose part of the 180 days. Filing an extension is standard practice for anyone doing a 1031 exchange in the back half of the year.
Identification Rules
Treasury regulations cap what can be identified in that 45-day window. Under the three-property rule, you can identify up to three replacement properties regardless of their combined value. Under the 200-percent rule, you can identify any number of properties as long as their combined fair market value does not exceed 200% of the value of the relinquished property.7eCFR. 26 CFR 1.1031(k)-1 – Treatment of Deferred Exchanges Identify more than the rule allows and the IRS treats it as no identification at all. A narrow exception applies if you actually acquire at least 95% of the aggregate value of everything you identified before the exchange period ends.
Matching the Numbers
Full deferral on the real property portion requires two things. The net purchase price of the replacement property must equal or exceed the net sale price of the relinquished real property, and all the net equity from the relinquished property must be reinvested. The replacement does not have to be the same type of real estate; a factory can be exchanged for an apartment building. Anything short on price or equity becomes taxable “boot.”
Where the Tax Still Hits
Even a textbook exchange leaves substantial gain on the table in a business sale. The tax comes from several directions.
The proceeds allocated to every non-qualifying asset are boot by definition. Inventory produces ordinary income. Equipment produces depreciation recapture under Section 1245, taxed as ordinary income at rates up to 37% depending on the seller’s bracket, on the portion of gain attributable to previously claimed depreciation.8eCFR. 26 CFR 1.1245-1 – General Rule for Treatment of Gain From Dispositions of Certain Depreciable Property A business that has aggressively depreciated its equipment can face a painful ordinary-income hit at closing. Goodwill and other capital assets produce capital gain. Covenants not to compete produce ordinary income. Non-cash consideration such as a buyer’s promissory note counts as boot at fair market value.
Debt relief is a source of boot that catches sellers who are not watching for it. If the relinquished real property carries a $500,000 mortgage and the replacement has only a $300,000 mortgage, the $200,000 of debt relief is treated as cash boot. The fix is to take on replacement debt at least equal to the debt relieved, or to add outside cash to the replacement purchase to close the gap. Discovering a shortfall after the exchange has closed creates a tax event you cannot undo.
Finally, the depreciation history on the real property does not disappear when the exchange succeeds. Gain attributable to prior depreciation on real property is unrecaptured Section 1250 gain, which faces a maximum federal rate of 25% when eventually recognized.9Internal Revenue Service. Topic No. 409, Capital Gains and Losses A 1031 exchange defers that recapture by carrying the depreciation history forward to the replacement property. The bill does not vanish; it moves. Sellers who chain multiple exchanges over decades can accumulate a large deferred recapture balance that comes due whenever they finally sell without exchanging.
Partnerships and the Drop-and-Swap
Partners who want deferral on the real estate face an extra step because a partnership interest cannot be exchanged. The workaround, known as a drop and swap, has the partnership distribute the real property to the individual partners as tenants in common before the sale. Each partner then runs their own 1031 exchange on their undivided interest.
The IRS scrutinizes these arrangements heavily. Each partner must hold the distributed property for productive use in a trade or business or for investment before exchanging it. A distribution executed the day before a pre-arranged sale looks like a step transaction designed to sidestep the partnership-interest exclusion, and the IRS has challenged that pattern. The safer path is to establish the tenancy-in-common structure well in advance of any buyer negotiations, ideally in a different tax year than the sale, following the guidelines of Revenue Procedure 2002-22 for arrangements that will not be recharacterized as a partnership.
The Related-Party Two-Year Rule
If the exchange involves a related person, whether a family member, a commonly controlled entity, or a business partner, Section 1031(f) imposes a two-year holding requirement.2Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment If either the related person disposes of the relinquished property or the seller disposes of the replacement property within two years, the deferred gain snaps back into income in the year of that early sale.
An anti-avoidance rule catches attempts to launder the transaction through a qualified intermediary. If a seller uses a QI for an exchange that, as part of a pre-arranged plan, ends up involving a related party within two years, the whole thing can be recharacterized as taxable.10Internal Revenue Service. Revenue Ruling 2002-83 “Related person” here pulls in family members, entities in which the taxpayer owns more than 50%, and the other relationships defined under Sections 267(b) and 707(b)(1).
Forms You Will File
A partial exchange on a business sale generates several IRS filings, and the numbers on them all need to reconcile.
- Form 8594, filed by both buyer and seller, reports the agreed allocation of the total purchase price across asset classes whenever goodwill or going-concern value is part of the deal.11Internal Revenue Service. About Form 8594, Asset Acquisition Statement Under Section 1060
- Form 8824 reports the like-kind exchange, including dates, property descriptions, and the deferred-gain calculation.12Internal Revenue Service. About Form 8824, Like-Kind Exchanges
- Form 4797 reports the sale of depreciable business property, covering both Section 1245 recapture on personal property and Section 1250 recapture on real property.13Internal Revenue Service. Instructions for Form 4797
- Schedule D reports capital gains on assets that are not subject to depreciation recapture, such as goodwill.
The values on Form 8594 should match the purchase agreement, and the amounts flowing to Forms 4797, 8824, and Schedule D should tie back to that same allocation. Consistency across the two parties’ filings is what keeps the return out of an examiner’s queue.