When attempting to exchange a business, exchanging the goodwill component is often a dead end. Goodwill of two different businesses may never be of like kind. Treas Reg § 1.1031(a)-2(c)(2). Goodwill associated with real estate, however, can generally be treated as real estate and exchanged tax-free for other real estate.
Certain types of real estate essentially constitute businesses in and of themselves. Examples of these are shopping centers, motels, hotels, quarries, and golf courses. In these types of transactions, it is easy to separate the real property from the tangible personal property, such as the furniture and bedding used in a motel. It is very difficult, however, to separate the real estate from its goodwill, including the value of the above-market leases, name, telephone number, and workforce in place.
It is probably not necessary to allocate goodwill from real estate of this nature. Under IRC § 197, goodwill can be amortized over 15 years. When Congress passed IRC § 197, it was concerned that taxpayers would attempt to divide goodwill from its associated real estate and amortize the goodwill over a very short 15 year period versus the much longer depreciation periods available for real estate. The regulations provide that for tax purposes, goodwill is not a separate asset from real estate:
“Section 197 intangibles do not include any interest in land. For this purpose, an interest in land includes a fee interest, life estate, remainder, easement, mineral right, timber right, grazing right, riparian right, air right, zoning variance, and any other similar right, such as a farm allotment, quota for farm commodities, or crop acreage base.” Prop Treas Reg § 1.197-2(c)(3).
Section 197 assets also do not include the value of leases. For example, purchasing a shopping center does not include a separate allocation for the value of the leases, even if the value of the real estate is increased because of the existence of a favorable lease. Prop Treas Reg § 1.197 2(c)(8).
A much different problem is raised when real estate is a mere component of a business. In this situation, the real estate must be separately valued, including any goodwill component. If possible, the allocation should be included in the purchase and sale agreement. The allocation of the value of each component of a business will be controlled by the provisions of IRC § 1060.