From Owner Occupied to Passive Income: How 1031 Exchanges Can Extend the Life of Your Business Real Estate Wealth

For many business owners, buying the building their company occupies is viewed as a business decision.

It should also be viewed as a long term wealth strategy.

When you own your commercial real estate, you are potentially building two valuable assets at the same time: the operating business and the real estate underneath it. The business may produce income today, while the real estate can appreciate, build equity, and eventually become part of a much larger investment strategy.

We call this The Second Exit™.

The first exit is the eventual sale or transition of your operating business.

The Second Exit™ is what happens with the real estate you own.

One of the most powerful aspects of owning your business real estate is that your future use of that equity does not necessarily have to remain tied to owner occupied commercial property.

Under Section 1031 of the Internal Revenue Code, qualifying real property held for productive use in a trade or business can generally be exchanged for other qualifying real property held for business or investment purposes. The IRS makes clear that like kind refers to the nature or character of the real property, not its grade or quality. Real estate can generally be like kind to other real estate even when the properties look completely different or serve entirely different purposes.

That creates an extraordinary opportunity for business owners.

An owner occupied office, warehouse, industrial building, or other qualifying commercial property may potentially be exchanged into an apartment building or other investment real estate.

The strategy can also work in the opposite direction.

An investor who owns multifamily real estate may potentially exchange that property into a commercial building that will be used productively in a business.

The building does not have to serve the same function.

The strategy can evolve with your life.

Understanding What “Like Kind” Really Means

One of the biggest misconceptions surrounding 1031 exchanges is the phrase “like kind.”

A business owner might assume that selling a warehouse requires buying another warehouse. An apartment owner might assume that selling a multifamily property requires buying another apartment building.

That is generally not how the rule works.

The IRS explains that qualifying properties are like kind when they are of the same nature or character, even when they differ in grade or quality. Improved real estate can generally be exchanged for unimproved real estate, and different categories of U.S. real property can potentially qualify as like kind.

More importantly for business owners, Section 1031 applies to real property held either for investment or for productive use in a trade or business.

That distinction creates enormous flexibility.

Consider two properties:

Property A: A 20 unit apartment building occupied by 20 residential tenants.

Property B: A 15,000 square foot commercial building occupied by your operating company.

The properties have completely different tenants, uses, income profiles, and operating characteristics.

But for purposes of a properly structured Section 1031 exchange, both may potentially constitute qualifying real property.

One is held as an investment.

The other is held for productive use in a trade or business.

That means your real estate strategy does not have to remain frozen in the form in which it started.

Strategy 1: Going From Multiple Tenants to Your Company as the Tenant

Imagine you have spent the last 10 or 15 years owning a multifamily property.

You have accumulated substantial equity, but you also own a growing business that is currently leasing its space.

You might be asking:

Why am I paying rent to somebody else while I have significant equity tied up in another piece of real estate?

This is where a 1031 exchange may become part of a broader business and real estate strategy.

Rather than simply selling the apartment building, recognizing the taxable gain, and then using what remains to buy a commercial building, you may be able to structure a qualifying 1031 exchange from the multifamily property into qualifying commercial real estate intended to be held for productive use in your trade or business.

The IRS specifically recognizes buildings, land, and rental properties as examples of real property that may qualify, provided the property is held for investment or productive use in a trade or business.

Think about what has changed economically.

Yesterday, you owned a building occupied by numerous tenants.

Tomorrow, you may own a building occupied principally by your own company.

Instead of collecting rent from residential tenants while simultaneously paying rent to a commercial landlord, you have potentially redirected your accumulated real estate equity into the property that supports your operating company.

You have gone from landlord and tenant to business owner and real estate owner.

That can be an important wealth building transition.

Owning Your Building Can Create a Second Balance Sheet

A successful operating business creates value.

But so can the real estate it occupies.

When your company leases, the landlord receives the rent and owns the appreciating asset.

When you own the building, your business can potentially help support an asset that you control.

Over time, loan amortization may reduce the debt. The property may appreciate. Improvements made for the business may increase its usefulness. The business owner may eventually reach retirement with meaningful equity in an asset separate from the operating company.

That separation matters.

A buyer of your business may want the business but not the building.

Another buyer may want both.

You may decide to retain the building and lease it to the buyer.

Or you may decide to sell the building and reposition the equity through another 1031 exchange.

Ownership creates options.

And options become increasingly valuable as you approach your eventual exit.

Strategy 2: From Owner Occupied Real Estate to Passive Investment Income

Now let’s reverse the strategy.

Imagine you started a company 25 years ago.

After several years of leasing, you purchased a commercial building for the business. Over the next two decades, the company grew, the mortgage balance declined, and the building appreciated substantially.

Eventually, you decide to sell the business.

This is where many entrepreneurs focus exclusively on their first exit: the sale of the operating company.

But there may be a second transaction sitting right underneath it.

The real estate.

Suppose the buyer of your company also wants to purchase the building.

Selling the business and selling the real estate are not necessarily the same transaction from a federal tax perspective. The IRS explains that the sale of a business generally involves the sale of multiple individual assets, and the tax treatment of those assets is determined separately.

Current Section 1031 treatment is limited to qualifying real property. Business goodwill, equipment, and other non real estate assets do not simply become eligible for 1031 treatment because they are sold alongside a building.

That makes advance planning extremely important.

The business sale may create one set of tax consequences.

The real estate sale may create another.

And the qualifying real estate may potentially be exchanged.

Instead of selling the building, paying the applicable taxes, and investing the remaining proceeds, the owner may consider a properly structured 1031 exchange into another qualifying investment property.

That replacement property could potentially be multifamily real estate.

Think about the transition.

For decades, your company was effectively the economic engine supporting your real estate.

After the exit, you might own an apartment building supported by dozens of residential tenants.

You have moved from:

Your company being the tenant

to

Multiple third party tenants being the tenants.

The operating business has been sold.

But the real estate wealth you accumulated during your entrepreneurial career may continue working for you.

The Second Exit™

This is the concept behind The Second Exit™.

Business owners spend enormous amounts of time thinking about how they will eventually sell their company.

What is my EBITDA?

What multiple can I receive?

Who will buy the company?

How do I maximize enterprise value?

Those are important questions.

But there is another question that should be asked years before the business is sold:

What will I own after I sell the business?

For business owners who also own their commercial real estate, the answer can be much more interesting.

Your first exit can monetize the company you built.

Your Second Exit™ can determine what happens to the real estate wealth you accumulated alongside it.

Perhaps you keep the building and collect rent from the buyer of your company.

Perhaps you eventually sell it.

Perhaps you execute a 1031 exchange.

Perhaps one owner occupied property ultimately becomes multifamily, industrial, retail, or another qualifying investment property.

The point is not that every business owner should pursue the same strategy.

The point is that owning the building gives you choices that leasing generally does not.

A 1031 Exchange Defers Tax. It Does Not Make the Tax Disappear.

This distinction is important.

A properly structured 1031 exchange generally defers recognition of qualifying gain rather than permanently eliminating it. The tax basis generally carries into the replacement property subject to the applicable rules and adjustments.

There are also strict requirements surrounding these transactions.

The taxpayer cannot simply sell the property, receive the money, and later decide to call the purchase of another building a 1031 exchange.

Among other requirements, the exchange must be structured to prevent the taxpayer from having actual or constructive receipt of the exchange proceeds. One recognized safe harbor is the use of a qualified intermediary.

Business owners contemplating the simultaneous or closely timed sale of a company and its real estate should therefore involve their CPA, tax attorney, qualified intermediary, and other advisors before the real estate closes.

Planning after closing can be too late.

SBA Financing Can Help Create the Beginning of the Strategy

Before there can be a Second Exit™, there often has to be a first acquisition.

That is where SBA financing can be particularly powerful.

The SBA 504 program, for example, can be used for qualifying fixed assets including the purchase or construction of existing buildings, land, and new facilities, as well as certain improvements and modernization projects.

For the right business, SBA financing can provide a path from:

Tenant → Owner

Instead of continuing to lease indefinitely, the company may be able to purchase the real estate it occupies.

And that purchase should not be viewed only through the lens of today’s monthly payment.

Consider the bigger picture.

What could the building be worth in 10 years?

What could the loan balance be?

What happens if the business grows?

What happens when the business is sold?

Could the building be retained and leased to the buyer?

Could it eventually be exchanged?

Could the equity ultimately become part of a passive real estate portfolio?

Those are long term ownership questions.

And they are exactly why commercial real estate financing can be so much more than simply obtaining a loan.

From Investment Property to Business Property and Back Again

The strategic flexibility is what makes this concept so compelling.

A business owner could theoretically move through several chapters during an entrepreneurial career.

Chapter One: Own multifamily or other investment real estate while building the operating company.

Chapter Two: Sell the investment property and complete a qualifying 1031 exchange into commercial real estate that will be held for productive use in the business.

Chapter Three: Operate the business from the building while building equity in both the company and the real estate.

Chapter Four: Sell the operating business.

Chapter Five: Sell or subsequently dispose of the qualifying business real estate and complete another properly structured exchange into qualifying investment real estate.

Chapter Six: Transition from active business ownership into a portfolio designed to generate investment income.

The specific tax consequences and eligibility have to be evaluated for each transaction, but the broader strategic lesson is important:

Your real estate can evolve as your life evolves.

You are not necessarily locked into being a multifamily investor forever.

And buying an owner occupied building does not necessarily mean that your capital must remain in owner occupied real estate forever.

Own the Building. Own More of Your Future.

For many entrepreneurs, one of the biggest financial decisions they will ever make is whether to continue leasing or purchase the real estate their company occupies.

There is no universal answer.

Sometimes leasing makes sense.

Sometimes owning makes substantially more sense.

But the analysis should extend well beyond today’s rent payment versus today’s mortgage payment.

You should be thinking about the next 10, 20, and 30 years.

You should be thinking about your business exit.

You should be thinking about your real estate exit.

And you should be thinking about how those two events can work together.

That is The Second Exit™.

Build the business.

Own the building.

Build equity in both.

And when the time eventually comes to move into the next chapter, evaluate whether Section 1031 can help reposition qualifying real estate from the property your business needed yesterday into the investment portfolio you want tomorrow.

ThinkSBA Helps Business Owners Get There

At ThinkSBA, we help business owners find the right financing strategy to acquire owner occupied commercial real estate.

Whether you are buying an existing building, constructing a new facility, expanding your company, or moving from leased space into property ownership, the financing structure matters.

SBA 7(a), SBA 504, and conventional commercial real estate financing can each serve different purposes depending on the transaction, borrower, property, and long term strategy.

Our job is to understand the complete transaction and help connect business owners with the financing solution and lender that make sense for their objectives.

As one of the premier commercial and SBA finance brokerages in the United States, ThinkSBA brings experience, lender relationships, and transaction knowledge to the table so business owners can evaluate more than simply whether they can buy a building.

We want them thinking about why they should own it, how they should finance it, and what that ownership could mean decades from now.

Because buying owner occupied real estate isn’t necessarily just about where your company operates today.

It can be about building the asset that helps fund your future tomorrow.

Own your building. Own your future. Plan for The Second Exit™.

This article is for educational purposes only and is not intended as tax, legal, accounting, or investment advice. Section 1031 transactions are highly fact specific. Business owners should consult qualified tax and legal advisors and a qualified intermediary before selling or transferring property intended for a like kind exchange.