Far too many physicians sell their business and investment property and pay capital gain taxes because they are unaware of provisions in the tax code that allow for deferral. Internal Revenue Code Section 1031(a)(1) states in part that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment." Examples of property types that typically qualify are vacant land, office buildings, warehouses, farmland, single-family rental units and shopping centers. Even leases with 30 or more years remaining are considered real property and can be traded for other real property.

How does one get started? The procedure is fairly simple as Treasury Regulations issued in April of 1991 provide a guideline for taxpayers to follow. Once a buyer for the property to be sold (the "relinquished property") has been found, a phone call to a selected "qualified intermediary" to assist with the Section 1031 exchange is all it takes to begin the process. The qualified intermediary will produce the necessary legal documentation required to facilitate the exchange process. Once the closing of the relinquished property has occurred, the taxpayer has 45 days from the date of closing to identify in writing to the intermediary the possible replacement properties. Due to significant restrictions, it is usually best to identify no more than three replacement properties. The final step is to close on one of the identified properties within 180 days from the date of closing of the relinquished property.

Although the 1031 tax code section is very liberal, various modifications over the years have resulted in a few additional restrictions. Partnership shares, notes, stocks, bonds, certificates of trust cannot be exchanged. A taxpayer who holds a partnership interest or shares in a corporation that owns real estate cannot trade that interest for similar share interests. Physicians should consult a tax expert or legal advisor in this situation.

With the reduction in capital gains tax rates a couple of years ago, taxpayers were given a rare break. However, this break was not as generous as originally proposed. Most taxpayers are aware of the new capital gains tax rate of 15 percent, lowered from the previous 28 percent rate. This is applicable for gain generated from the sale of capital assets held for more than 12 months. At the last minute, however, Congress altered the tax rate for recapture of depreciation taken on real estate to be taxed at 25 percent. This higher rate is applicable for all depreciation taken after May 6, 1997. Combining the 25 percent depreciation recapture rate with state and federal tax rates could cost a taxpayer who sells business real estate up to 30 percent or more of their profit. On the other hand, a property owner who chooses to perform an IRC Section 1031 tax deferred exchange can defer taxes on the all of the capital gain! This leaves the prudent exchangor with the entire amount available for reinvestment.

Many physicians are unaware that personal property used in a business, such as a medical practice, can be exchanged as well. The major difference between a real property and personal property exchange is what the Internal Revenue Service considers "like kind" property. I.R.C. Section 1031 defines like kind as "...property held for productive use in a trade or business or for investment." Like kind as it applies to real property is very broad in definition. Determining whether personal property is like kind to other personal property requires a much narrower scope. The Internal Revenue Code does not define "like kind." The IRS has published regulations that can be used to decide if an exchange involves like-kind properties. The Treasury Regulations distinguishes between two types of personal property: depreciable tangible personal property (DTPP); and other personal property (OPP), which consists of intangible and non-depreciable personal property.

DTPP can only be exchanged for other DTPP. These properties must be of a "like class" or "like kind." In determining whether DTPP is of a like class the Treasury Regulations designate 13 general asset classes. These classes combine particular types of personal property into a certain class group. Some examples of these groups are office furniture and fixtures, information systems, airplanes and helicopters, automobiles and taxis, and buses.

The Regulations also designate that personal property can fall within product classes contained in the North American Industry Classification System. These numeric codes can be used as an alternate method to define the characteristics of a particular property.

OPP is difficult to classify as like kind to other OPP. It does not fall within the like class safe harbor available to DTPP. Intangible personal property, such as a lease or copyright, can be considered like kind to similar intangible property. The determining factors are the nature and character of the rights involved and the nature and character of the underlying asset.

Selling a business can create more than one personal property group in which to exchange. The IRS looks at the sale of a business as an exchange of each asset to be transferred, and not the exchange of the business as a whole. The underlying assets of a business (e.g., lease value, covenant not to compete, equipment and fixtures) will need to be analyzed in respect to their comparable replacement property. Each asset is placed into the proper exchange group. An exchange group is a subgroup of the total assets exchanged. Every exchange group will either have a surplus (trading up in value) or a deficiency (boot). When the total fair market values of the properties exchanged are different, the value equal to that difference is called the residual group. The property in the residual group will consist of cash and other property that does not fit into an exchange group.

An example of a business exchange would be the exchange of one medical practice for another. The relinquished medical practice value consisted of: (1) the medical equipment (x-ray machines, etc.) and office fixtures; (2) a covenant not to compete; (3) lease value for the below market lease of the office; and (4) client patient lists and files. The medical practice acquired will generally have similar components of value. To balance this exchange each separate component is matched up with its like kind counterpart. A surplus in one of the exchange groups is not taxable as the Regulations allow for trading up in value. Any deficiency – going down in value – would be taxable as "boot."

The Regulations provide the non-yielding rule that goodwill and going concern value in one business can never be like in kind to goodwill and going concern value in another business. In the example of the medical practice exchange, the client patient lists and files would probably be viewed by the IRS as goodwill, and should not be included in the exchange. A prudent tax planner would attempt to allocate value to the depreciable or amortizable personal property, such as the medical equipment and office fixtures, to avoid this problem. Additional personal property not eligible for exchange treatment is inventory. The inventory of a business is held for resale and does not fall within the definition of Section 1031 property.

Anyone considering deferring tax under IRC Section 1031 should obtain competent tax/legal advice before proceeding with a transaction. A mistake can be costly.