Many car wash owner/operators have thought of selling their car washes and perhaps buying another location for car wash development and brand expansion or making some other type of commercial investment such as self-storage facilities, convenience stores, apartment buildings, or strip centers. Perhaps they want to look at more passive investments for their future as they develop an exit strategy for their business. The U.S. tax code allows for tax deferred “like-kind” exchanges of real estate. However, all investors should be aware that the Tax Cut and Jobs Act of 2017 made changes to the qualifications for 1031 property exchanges and will have a substantial effect on future property exchanges.
Section 1031 of the tax code allows for tax-free property exchanges of “like-kind” properties to defer or avoid capital gains and related federal income tax liability. 1031 Exchanges only apply to real property and securitized properties, and no longer include personal property, bonds, stocks, livestock, and other types of properties. This 1031 program is important to American property investors, since a substantial number of commercial car wash property transactions in the United States participate in 1031 Exchange programs.
WHAT IS A 1031 EXCHANGE?
A 1031 Exchange is a way the IRS allows investors to move capital gains from one property to another qualifying property to defer capital gains taxes on the sold property. The U.S. Treasury regulation section 1031 provides that real property qualifies for an arm’s length 1031 Exchange if it is in the 50 U.S. states or the District of Columbia and if it is held for productive trade or business or for investment purposes. Commercial car wash properties generally qualify for 1031 Exchange programs when the real estate or long-term lease are available to exchange.
The owner/operator — for the rest of the article called the taxpayer — must follow these rules and other specific requirements to qualify for this benefit.
The components of a 1031 Exchange program are:
1. Relinquished property or the real property that is being sold.
2. Replacement property or the real estate that is replacing the sold property.
3. Qualified intermediary (QI) or the third party 1031 exchanger who transacts the exchange for the seller of the relinquished property, holds the proceeds from the transaction, and then transacts the exchange for the buyer for the replacement property and prepares documentation for the taxpayer to file with their tax return.
4. Independent closing agent or closing attorney that is an unrelated third party that conducts the closing and recording of the deed on either property. The closing agent is responsible for preventing the taxpayer from realizing any cash benefit and immediately records the deed and transfers the funds to the QI once the transaction completes.
The IRS defines real property for the purposes of a 1031 Exchange as:
1. Raw land (forest) or land for development.
2. Leasehold properties with a minimum term of 30 years.
3. Commercial building used for investment or to be used in the taxpayer’s business.
4. Single family income properties and multifamily buildings.
5. Conservation easement and other property easements.
Personal property and personal residences do not qualify for 1031 Exchange with limited exceptions.
Rules of the 1031 Exchange:
1. Real property of “like-kind” nature in the 50 U.S. states and D.C., some USVI.
2. Relinquished property proceeds must not be constructively received by the taxpayer and must be transferred immediately after closing to be held by the 1031 QI or the closing agent or attorney.
3. Replacement property value must be equal to or greater than the relinquished property.
4. Up to three replacement properties to be used for the exchange can be identified in writing to the QI (identified replacement properties) or before 45 days after the closing or transfer of ownership of the relinquished property.
5. Replacement properties must be purchased from non-related parties of the transaction and must be arm’s length transactions and must reflect fair market value.
6. One, two, or all three of the identified replacement properties may be purchased as part of the replacement exchange within 180 days of the sale of the relinquished property (ies). However, the total fair market aggregate purchase price of all properties combined may not exceed 200 percent of the relinquished property (ies) value.
7. If there are any excess monies or other benefits to the taxpayer, or taxpayer receives any cash from the transaction, then tax is paid on that “boot” (more about which below).
8. There is no holiday holdover or extensions to the 45-day and 180-day rules — the timelines are absolute.
9. Up to 15 percent of the attached capital equipment necessary for operating the structure or operating an integrated business such as a car wash can be transacted. If the relinquished property has integrated personal property sold with the real estate, then a “like-kind” replacement property must be used to avoid taxes on the replacement capital equipment, such as a self-service car wash property exchanged for another self-service car wash property.
10. The QI will create an IRS form 8824 to file with the taxpayer’s tax return and other state specific documentation the taxpayer’s state taxing authority will require.
A 1031 Exchange Reverse Exchange is a program that allows the taxpayer to identify a replacement property in advance of the sale of the relinquished property. A QI is still used but instead of the sale of the relinquished property occurring first, the replacement is identified first. In this case, the taxpayer has 45 days to identify the relinquished property and has 180 days to sell the relinquished property. This method is used most frequently in “tight” commercial real estate markets when there are limited replacement properties available.
BOOT OR TAXABLE MISTAKES
“Boot” is cash or other items of value received or benefit derived from the transaction to the taxpayer, also known as “net cash received,” excess borrowing on the replacement property, or reduction of the total debt on the replacement property, and any sale proceeds the taxpayer receives directly from the transaction including earnest money provided by the QI and returned to the taxpayer on a failed transaction. Failure to have as much debt or more on the replacement property is called “Debt Boot” and is taxable. An experienced 1031 Exchange company, one that specializes just in 1031 Exchanges, should be consulted to avoid this very expensive pitfall.
A taxpayer-identified relinquished commercial car wash property sells for $1,000,000. It has outstanding debt (bank loan) on sale day of $250,000, which is paid off with taxpayer proceeds by the closing agent. Closing agent wires proceeds, less closing services and recording fees of $5,000, to the QI in the amount of $745,000. The taxpayer identifies three replacement properties with values of $1,100,000, $1,400,000, and $1,200,000. The taxpayer selects replacement property for a purchase price of $1,100,000 (the sale price is greater than the relinquished property sale price). The taxpayer assigns the purchase contract to the QI and applies for a new loan on the property selected. On sale day, the QI and new lender wire monies to the closing agent who facilitates the sale documentation and records the new deed under the QI who holds title to the property in trust for the taxpayer. Taxpayer makes loan payments to the lender on the replacement property.
Car wash owner/operators and potential sellers should be aware of the 1031 Exchange program, which, when used properly, will be a benefit to both car wash buyers and sellers alike. A licensed CPA (not a bookkeeper), tax attorney, 1031 exchanger, or IRS enrolled agent should be consulted well before contemplating the selling or buying of any commercial real estate property. There are huge tax consequences if this 1031 Exchange program is not administrated and managed properly. An improper or poorly managed transaction can cost taxpayers much more than they could potentially have saved.
Hire a commercial real estate broker that has reasonable 1031 Exchange experience and works in the sector the taxpayer wants to invest. Use a commercial closing agent and/or attorney to help guarantee correct execution of the transactions and required paperwork. Interview one or more 1031 Exchange companies, as fees and other services vary.
Mark W. Gerhart, president of American Car Wash Brokers Inc., is a licensed real estate broker in the state of Colorado, focused on car wash and detail, convenience store, quick lube, and other automotive-use property sales.