You've occupied your old facility for many years. It's risen greatly in value, even though you've claimed so much depreciation on it over the years that it has a very low basis for tax purposes.
Business is going great guns and you need to add more capacity. You'd like to sell the old facility and build a larger, modern facility. But one thing is stopping you: Not only must you raise the funds to pay for the greater cost of the new facility, but also you must pay the capital gains tax on the sale of the old one. At a tax rate of as much as 35% for a corporation or 20% for an individual, can you possibly afford it?
Most emphatically, yes!
You’ve probably heard of a "like-kind exchange." Under Section 1031 of the Internal Revenue Code, you can avoid recognizing a gain on the sale of your old facility. You have held it for investment or use in a trade or business. You will exchange it for real estate of 'like kind,' i.e., for a new facility, which you also plan to hold for investment or use in a trade or business. You must identify the new facility within 45 days after you close the sale of the old facility. You must close the purchase of the new facility by the earlier of 180 days following the date you close the sale of the old facility, or the date you file your tax return for the year you close the sale of the old facility.
To avoid recognizing any gain, the purchase price of the new facility must equal or exceed the sale price of the old facility. In your case, the purchase price for the building site for your new facility is much less than the sale price of your old facility. The rules don't permit you to use your sale proceeds to first buy a building site and then construct a new plant on it. You must buy the building site already improved with the new facility. How can you possibly do that?
How can you possibly build a new facility in only 180 days? Can you afford to close the sale of and vacate the old facility--and shut down your business--while your new facility is under construction?
Your answer to all these questions is a cooperative construction contractor and a smart tax lawyer. They can save you a lot of money.
For a good customer such as you, a contractor "in the know" about like-kind exchanges may agree to buy the building site selected by you. He then proceeds to construct the new facility. You arrange and guarantee financing for your contractor's purchase and construction activities. In the meantime you continue to operate your old facility, and market it for sale.
You time the closing of the sale of your old facility to occur only when the new facility is ready to start production. You have time to move inventory, property and personnel out of the old facility and right into the new one. This way, your business isn't interrupted.
At the same time, you can meet the requirements for a like-kind exchange. You can close the sale of the old facility. Then you can use the proceeds to buy the building site, as already improved with the new facility, from your contractor. This way you closely follow the sale of your old facility with the purchase of your new facility, meeting the 45- and 180-day deadlines. And your purchase price for the new facility meets or exceeds the sale price for the old facility, because your contractor has had the opportunity to improve the building site with the new facility.
Consider the numbers in the following example. Say your tax basis in your old facility, after depreciation, is $100,000. You know you can sell it for $500,000. This would result in a gain of $400,000, which at a 35% corporate tax rate would mean you pay $140,000 in taxes. That's $140,000 you won't have to invest in a new facility. However, if you can avoid recognizing the gain, $140,000 will go a long way, particularly when leveraged with financing, to build a new facility.
Your building site will cost $100,000. Constructing your new facility will cost $900,000, resulting in a total cost of $1,000,000. If you structure the transaction as a sale of your old facility, followed by the purchase of your new facility, then you will have $360,000, after taxes, to invest in your new facility. You must invest or borrow the other $640,000. However, if you do a like-kind exchange, your requirements for additional investment or borrowing decrease by more than 20%, to $500,000.
Next time you trade up, do it the smart way. Consider a build-to-suit, like-kind exchange.
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William W. Hall is a partner in the Grand Rapids office of Warner Norcross & Judd. Mr. Hall focuses his practice on real estate issues. He may be reached directly at 616.752.2143. Because each business situation is different, this information is intended for general information purposes only and is not intended to provide legal advice.
West Michigan Commercial Development & Real Estate Quarterly