Save taxes when selling a dental practice with a Section 1031 exchange

A dental practice is sold 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 may pay federal and state taxes of up to 40% of the gain. 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 kit at the time of sale.

If a corporation owns real estate, the gain is taxed at the highest corporate rate. If an individual owns the real property and leases it to the corporation or other legal entity, the prior depreciation tax is 25% and excess depreciation gain is 20%. Goodwill, patient records, and accounts receivable are also assets that are generally included in the sale of a dental office and will be taxed at a rate of 20%. It goes without saying that the tax liability can be substantial as a result of a total 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

Capital gain $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 until much later. It’s called a Section 1031 tax-free exchange.

Tax deferral through a tax-free exchange

Section 1031 of the Internal Revenue Code has been in existence since the early 20th century. If you buy a property “of the same type” within six months of the sale of the practice, your taxes will be deferred, as long as the various rules are met. 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 may be fully or partially tax-free. If you have sold your practice and are buying another one, you would qualify as a full trade-in 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 due. Another example of a partial exchange is where a practice including real estate is sold and the dentist subsequently buys an apartment building for rental property. If the construction cost was greater than the property sold, no taxes would be paid on that part. Taxes would be paid on the other assets sold.

Tax-free Section 1031 exchanges are a great way to defer or, in some cases, eliminate 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.