Multi-Unit Franchisee Magazine Issue IV, 2011 | Page 66
Creative Financing
By Andy Gustafson
Tax-Deferred Exchanges
A creative financing tool for franchisees
S
mart franchisees are always looking for ways to increase
cash flow and reduce expenses. One strategy to consider
for improving the bottom line is to replace a franchise
property with one in a better location or to upgrade equipment.
Franchisees can use a creative financing tool, 1031 exchanges,
to defer capital gains and recaptured depreciation taxes when
purchasing real and personal property of equal or greater value.
Savings on deferred taxes represent interest-free loans for higheryielding acquisitions. Successful completion of a 1031 exchange
depends on finding eligible replacement property and meeting
identification and transaction deadlines.
How a 1031 exchange works
Tax-deferred exchanges, also known as 1031 exchanges, are enforced by the IRS. According to IRS Code
Section 1.1031, no gain is recognized on
property held for productive use in business
or investment when exchanged for like-kind
business or investment property (property
denotes real and personal property). The
replacement property must be of equal or
greater value than the property sold, or a tax
is triggered on the difference. The franchisee
must identify replacement property within 45
calendar days and complete the transaction
within 180 calendar days. [Extension of the
identification timeline and exchange completion
can be granted given presidentially declared
disasters including flooding, tornadoes, hurricanes, fires, terroristic or military action, or
exchangor (taxpayer) serving in a combat zone.]
Examples of eligible replacement property
options include land and improvements; improvements to an existing building; improvements to land already owned; and leasehold
interests.
Franchisees can upgrade equipment and
defer taxes when replaced with the same likekind, like-class of furniture, cooking equipment, refrigeration, and
fixtures. The franchisee’s accountant can classify like-kind equipment based on 13 general asset classes or the North American
Industry Classification System (NAICS). The accountant can also
determine whether it makes sense to initiate an exchange when
the gain on personal property is sold.
The qualified intermediary is responsible for drafting the
exchange documents and holding the exchange funds in a safe,
segregated, liquid escrow account. A person who has acted as the
exchangor’s employee, attorney, accountant, investment banker,
broker, or real estate agent within the two-year period before
the exchange cannot serve as a qualified intermediary. Routine
financial title insurance, escrow, or trust services will not be taken
into account.
1031 exchange benefits
Franchisees can engage in exchanges for the reason of consolidation, relocation, diversification, appreciation, cash flow, and
depreciation. A 1031 exchange allows for the indefinite use of
taxable dollars interest-free toward the replacement property.
However, the transaction is not tax-free, and the tax obligation
is deferred or pushed forward indefinitely until the replacement
property is sold. If the personal property is not exchanged, then
the tax is paid on the personal property. The interest-free loan
or principal provides a return given the time value of money and
appreciation of the replacement property. The potential risk is a
higher tax rate than the return on the principal
when the taxes are eventually paid.
Franchisees can
1031 exchange strategies
use a creative
Depending upon whether the new property
is a built to suit, starting with raw land, or imfinancing tool,
provements are made to an existing site will
determine if a reverse or forward exchange
1031 exchanges, to is structured by the qualified intermediary.
If improvements or a build-to-suit are not
defer capital gains required, then most likely this will be a forward exchange, in which the taxpayer closes
and recaptured on the old property first and then completes
the transaction for the replacement property.
depreciation taxes If improvements or a build-to-suit are needed,
the steps can be either a forward or a reverse
when purchasing exchange. In a reverse, the new property is
acquired first, followed by the identification
real and personal of improvements and old property to be sold,
constructing the improvements, and selling
property of equal or the old property.
greater value.
How to avoid potential risks
64
Timing is crucial for successful completion of
a 1031 exchange. The taxpayer will have to pay capital gains and
depreciation taxes if the transaction is not completed in 180 days.
Personal property acquired but not affixed is not eligible for the
tax deferral. Capitalized costs such as accrued real estate taxes,
rent, and planning costs are eligible for gain deferral.
For example, a multi-unit fast food restaurant franchisee initiated a 1031 exchange. The franchisee sold one of their locations
with the intent of purchasing land and building a new store. The
first leg of the exchange went smoothly and the old or relinquished
real and personal property were sold. The funds were wired to a
segregated escrow account under the franchisee’s tax identification number, earning interest.
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