Selling the Hotel, the Restaurant, the Practice: Only Part of That Price Can Be Exchanged

Owner operators selling a hotel, restaurant, care home, car wash or professional practice often think of it as one transaction. The buyer writes one cheque, the lawyers produce one contract, and the business changes hands.

For tax purposes it is not one sale. It is a sale of real property, a sale of tangible personal property, and a sale of intangible assets, each treated differently. Only the first can go into a 1031 exchange.

What changed in 2018?

Before then, personal property could be exchanged for like kind personal property, so equipment and furnishings could be included in a broader exchange alongside the real estate.

Since the 2017 tax law took effect, Section 1031 applies only to real property. Equipment, furniture, vehicles, inventory, goodwill and other intangibles no longer qualify. Gain on those assets is recognised in the year of sale.

What are the three categories?

Real property. Land, buildings and structural components, plus certain permanently installed systems. This portion can be exchanged.

Tangible personal property. Furniture, kitchen equipment, computers, vehicles, linens, signage in some cases. Not exchangeable. Often subject to depreciation recapture at ordinary income rates, which can be higher than the 25 percent that applies to building depreciation.

Intangible assets. Goodwill, going concern value, customer lists, trade names, non compete agreements. Not exchangeable, and taxed according to their own rules.

Why does allocation matter so much?

Because the allocation in the purchase agreement drives how much of your price can be deferred and how much is taxed now.

A hotel selling for 6 million dollars might be allocated 5 million to real property, 700,000 to furniture and equipment, and 300,000 to goodwill. The 5 million can be exchanged. The rest produces current tax.

Shift the allocation and the outcome changes. That is why buyers and sellers sometimes want different allocations: buyers often prefer more value in shorter lived assets they can depreciate quickly, while sellers doing an exchange often prefer more in real property.

The allocation must be reasonable and supportable, and both parties generally report consistently. It is a negotiation constrained by the facts, not a free choice.

What counts as real property?

The definition includes land, inherent permanent structures and structural components. In an operating business, items like built in walk in refrigeration, elevators, plumbing and electrical systems serving the building generally qualify, while equipment serving the business operation generally does not.

The line can be genuinely difficult. A commercial kitchen contains both. Getting it right usually needs a cost segregation style analysis and a CPA familiar with the asset type.

How is the recapture handled?

Personal property that has been depreciated, often aggressively, is typically subject to recapture at ordinary income rates on sale. For a business with substantial equipment, that can be a significant bill in the year of sale even when the real estate is exchanged successfully.

Owners are frequently surprised by this, because they think of the whole sale as deferred.

What about the operating entity?

If the business is held in an entity and the buyer purchases the entity's shares or membership interests rather than the assets, there is no sale of real property to exchange. Stock and partnership interests are excluded from 1031 treatment.

Structuring as an asset sale, with the real property separately identified, is usually necessary for an exchange. That has consequences for the buyer as well, so it needs to be agreed early.

Can the real estate be separated in advance?

Sometimes. Owners occasionally hold the real property in one entity and the operating business in another, leasing the building to the business. That structure can make a later sale cleaner: the building can be sold and exchanged while the business is sold separately.

Setting that up long before a sale is far easier than restructuring during one.

What does the exchange side look like?

The real property portion follows the normal rules. A Qualified Intermediary must be engaged before closing, the proceeds attributable to the real estate go to the intermediary, and replacement real property must be identified within 45 days and acquired within 180.

Owner operators selling a business often want out of active management entirely, so the replacement is frequently net lease property or a passive fractional interest rather than another operating asset. Those interests are securities available to accredited investors only where DSTs are involved, and carry illiquidity and costs.

One practical point: the cash from the non exchangeable portion, the equipment and goodwill, arrives in your hands and is taxable. It is often used to pay the tax on itself. Model that before closing so the cash is not spent elsewhere.

What to do first

If you own a business with real estate and expect to sell within a few years, ask your CPA to model the allocation now. Understand which assets carry recapture, how much of the price is likely to be real property, and whether separating ownership of the building would help. Then make the allocation part of the negotiation rather than an afterthought at closing.

Nothing here is tax, legal or investment advice. Asset classification is technical and fact specific. Confirm your position with your CPA and attorney before selling.