Save taxes when selling a dental office with a section 1031 exchange
A dental office sells for a variety of reasons: retirement, moving to another city, or even health concerns. Regardless of the reason, it is critical to consider the tax ramifications of the sale. Depending on the type of assets sold, the seller can pay federal and state taxes of up to 40% of the profit. For example, most, if not all of the equipment sold is likely to be taxed at the highest rates for individual and corporate owners. This is because most dental equipment is written off in the year of purchase or depreciated over a 5-7 year period. Therefore, there is usually a minimum amount of base in the equipment at the time of sale.
If a corporation owns real estate, the profit is taxed at the highest corporate rate. If a person owns the real estate and leases it to the corporation or other legal entity, the prior depreciation tax is 25% and the gain in excess of depreciation is 20%. Goodwill, patient records, and accounts receivable are also assets that are generally included in the sale of a dental practice and will be taxed at the 20% rate. It goes without saying that the tax liability can be substantial as a result of a direct sale.
Example of direct sale of a practice and resulting tax liability:
Team: $ 120,000 profit X 40% tax rate = $ 48,000
Accounts Receivable: $ 20,000 profit X 20% tax rate = $ 4,000
Records: $ 90,000 profit X 20% tax rate = $ 18,000
Real estate $ 250,000 profit X 20% tax rate = $ 50,000
Goodwill $ 115,000 profit X 40% tax rate = $ 46,000
As you can see, the total tax liability of $ 166,000 on this hypothetical sale is staggering, but there is a way to defer these taxes well into the future. It’s called a Section 1031 tax-free exchange.
Defer taxes through a tax-free exchange
Section 1031 of the Internal Revenue Code has existed since the early 20th century. If you buy a “similar” property within six months of the practice sale, your taxes will be deferred, as long as the various rules are followed. There are two time periods involved. The first, called the identification period, requires the selling dentist to identify one to three replacement properties within 45 days. The second period involves the actual purchase of the property. That must occur within 6 months of the sale of the practice.
Exchanges can be totally or partially tax-free. If you have sold your practice and are buying another, it would qualify as a full trade if you are buying a more expensive practice. If it is less than the assets sold, it would result in a partial exchange and some taxes would be owed. Another example of a partial exchange is one in which an office that includes real estate is sold and the dentist later purchases an apartment building for income. If the construction cost were more than the property sold, no tax would be owed on that part. Tax would be owed on the other assets sold.
Section 1031 tax-free exchanges are a great way to defer or, in some cases, eliminate the tax liability. It is very important to follow the rules to the letter. Therefore, it is advisable to seek the guidance of an experienced attorney and / or CPA prior to implementation.