1031 Exchanges in Agriculture

Apr 5

Exchange Basics

The 1031 tax-deferred exchange gets its name from Section 1031 of the Internal Revenue Code. The guideline makes it possible for landowners to sell property at a gain, reinvest the sale proceeds into like-kind property and defer any capital gain taxes on the sale. Multi-generation agricultural properties typically have very little tax basis, so when they are eventually sold, the assessed gain and tax can be very significant. By using the 1031 exchange to trade out of the farm or ranch into alternative income-producing real estate, you can defer and potentially eliminate that tax burden. Under current law, the deferred tax liability may be eliminated entirely when your heirs inherit the property. Therefore, a 1031 exchange may enhance your income and increase the estate your heirs eventually inherit.

Types of Exchanges

When selling a farm or ranch with the intention of using the 1031 exchange to defer tax, typically landowners will opt for the ‘Deferred Exchange’ which is the type of exchange we will focus on in this discussion. However, here are the four available options at your disposal:

Simultaneous Exchange: This is when a relinquished property is exchanged for the replacement property at the same time. In essence, this would be a land swap between two parties. Though rare nowadays, the Simultaneous Exchange typically occurs between landowners who own adjoining properties.

Deferred Exchange: This is the most common type of exchange, also termed the ‘Delayed Exchange’ which occurs when there is a time gap between the transaction of the relinquished property and the acquisition of the replacement property. A Deferred Exchange is subject to strict timelines which we will explain.

Reverse Exchange: This exchange allows landowners to first acquire a replacement property and later dispose of the relinquished property. In essence, this would be the opposite timeline of a Deferred Exchange.

Improvement Exchange: This exchange method allows the landowner to build on, or make improvements to, the replacement property, using the exchange proceeds prior to closing.

Exchange Process

The four steps of the 1031 exchange process are as follows:

Relinquish Property: Arrange for the sale of your land while considering the 45-day and 180-day timelines explained below.

Transfer Proceeds: At closing the sale proceeds from your relinquished property are transferred by the closing agent directly to a qualified intermediary. You must wait until the exchange is complete to take control of cash or other proceeds.

Identify Replacement Property: Within 45 days of closing on the relinquished property it is required that you identify, in writing, potential replacement properties. Failure to identify at least one replacement property within 45 days results in the exchange becoming void requiring the QI to return the proceeds to you leading the sale to become taxable.

Acquire Replacement Property: Within 180 days of closing on the relinquished property the exchange must be completed. Failure to close the transaction of the identified property or properties within 180 days results in the exchange becoming void requiring the QI to return the proceeds to you leading the sale to become taxable.

Exchange Timelines

The two strict deadlines that govern the 1031 exchange process are the identification of a replacement property in writing within 45 days and acquisition of a new replacement property within 180 days. If the exchange cannot be completed within your tax deadline, you may be able to file for an extension to align with the 180-day exchange period

45-Day Identification Rule: Within 45 days after closing the sale of your relinquished property, it is required to identify potential replacement property or properties. Your qualified intermediary will provide you with the property identification form, which you must complete and return in no more than 45 days.

There are no extensions of this deadline. After the 45-day period has expired, you cannot substitute any of the previously identified properties. You must either exchange into one or more of your identified properties, or cancel the exchange and pay the tax instead.

You are allowed to identify more than one potential replacement property, subject to the following rules:

Three Property Rule: You may identify a maximum of three properties, regardless of their values.
200% Rule: You may identify any number of properties as long as their aggregated total fair market value does not exceed 200% of the value of your relinquished property.
95% Rule: You may identify any number of properties as long as the aggregated total fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregated total fair market value of all the identified properties.

180-Day Replacement Rule: Within 180 days after closing the sale of your relinquished property, it is required to close on the purchase of your replacement property and complete your exchange by the earlier of:

No later than 180 days after closing the sale of your relinquished property.
The due date (with extensions) of the income tax return for the year you sold your relinquished property.

If the 180 days extends beyond your tax filing deadline, you would need to file an extension for your tax return. If an extension isn’t filed, the deadline to close on your replacement property will be the filing date of your tax return.

Things to Consider: When it comes to the 1031 exchange deadlines, it’s important to be diligent and proactive during this timeframe. We recommend beginning your search for replacement property at least 30 days prior to the closing of your relinquished property’s sale. In doing so, you will be one step ahead when it comes to deadlines, due diligence and negotiation leverage. When a seller knows you’ve formally identified their property as a replacement, you risk being in a poor negotiating position if your only options are to accept the seller’s terms or pay the significant tax bill.

Multi-generation agricultural properties are often composed of separately deeded parcels purchased at varying prices throughout the years resulting in a range of cost basis figures. If you wish to conduct an exchange on part of a ranch while taking cash out of the sale, consider exchanging the parcels with the lowest cost-basis or the greatest assessed gain while selling for cash the parcels with the highest basis or the lowest assessed gain.

Exchange Requirements

Section 1031 exchanges come with strict, elaborate deadlines. If the rules are not followed accordingly, the penalties can be significant. The most notable requirements to be made aware of are:

Qualifying Property: For relinquished and replacement properties to qualify under 1031 exchange, the real estate must be held for productive use in a trade or business or held for investment purposes. Personal use and personal residence properties do not qualify.

Like Kind Requirement: The exchanging properties must be like-kind. In other words, both the relinquished and replacement properties must be held for business or investment purposes though the exchanging real estate doesn't need to be of the same real estate class. For instance, agriculture land and operations may be exchanged for commercial, industrial or residential investment properties.

Qualified Intermediary: In a 1031 exchange, you must wait until the exchange is complete to take control of cash or other proceeds. During this time, such proceeds must be held by a qualified intermediary.

The intermediary’s role is to acquire the relinquished property from you, transfer it to the buyer, hold your sale proceeds in escrow, use the proceeds to acquire your selected replacement property, and complete the exchange by transferring the replacement property to you. The intermediary will also assist by preparing all required documents to complete the exchange process.

Taking Title: The title of your replacement property must be taken in the same name in which the relinquished property was held. For example, if your farm or ranch is held by a corporation or partnership, it is the corporation or partnership that must take title to the replacement property.

Cash, Debt and Boot: In the investment world, the term ‘boot’ is used to describe the value of cash, debt relief, or non-like-kind property that you receive in an exchange of your assets. If you don’t reinvest all your profits, boot is formed and will be taxed to the extent of your gain on the sale. We recommend taking steps to avoid developing boot in your 1031 exchange.

Boot can result from multiple scenarios, but often occurs from a partial exchange or trading down in an exchange when the relinquished property is worth more than the replacement property. Common reasons for partial exchanges may be to establish cash reserves, diversify into non-real estate investments or reduce overall indebtedness.

In order to defer 100% of the gain in an exchange, you must maintain or increase your equity and maintain or increase your debt. If either are decreased, the difference will result in boot and will be taxed to the extent of your gain on the sale. Debt you have on the land will be paid off at the closing of the sale by the closing agent. You will be taxed on this debt reduction unless you take out an equal or greater amount of debt on your replacement property.

After Your Exchange

Section 1031 of the Internal Revenue Code states no specific time period in which you are required to hold property after an exchange is complete, however, it is recommended to hold the replacement property for at least two years before the property is sold or converted to personal use. In exchanges between related parties, the property is in fact required to be held for a minimum of two years.

After an exchange, your tax basis from your relinquished property carries over to the replacement property. As a result, there is no step-up in basis for depreciation purposes, and future depreciation deductions will be based on the carryover basis.

Your deferred gain will also carry over and be recognized in future years if the replacement property is ever sold in a non-exchange transaction. At that time, both the deferred gain plus any additional gain realized since the purchase of the replacement property would be subject to tax.

When trading up in an exchange into a more expensive replacement property by contributing additional cash or taking on additional debt, the property’s tax basis will be increased.

Benefits of the 1031 Exchange

The 1031 exchange process allows you to defer and potentially eliminate taxes, build wealth, generate higher income and diversify.

Eliminate Tax Burdens: You may be able to eliminate the deferred tax entirely when your heirs take hold of the real estate. Under current tax law as of this writing, if you hold your replacement property until death, your heirs will receive a tax-free step-up in basis to the property’s fair market value.

Put Your Equity To Work: By deferring your tax bill, you can put 100% of your equity to work for you. This enables you to invest more in income-producing real estate, which in return should generate more income than if you had invested after-tax capital.

Transition Into Commercial Real Estate: The 1031 exchange process equips you with an effective opportunity to transition into owning commercial real estate providing you with passive income. This can be a great solution for retirement, after the physical demands of operating a farm or ranch operation become overwhelming. Rather than investing in a single property, we encourage our clients to consider diversifying into two or more properties to reduce risk. This also allows opportunity to diversify by location and real estate class offering further diversification.

In Conclusion

The 1031 exchange is a dynamic wealth building implement that provides you with the opportunity to indefinitely defer or eliminate your capital gains tax on the sale of appreciated agriculture land while potentially increasing your income and wealth. We strongly recommend taking advantage of this effective tool to those interested in saving tax on their property sale with the opportunity to reinvest. Terra West Group has helped many landowners save on tax, generate more income and increase diversification with this process. If you’re interested in taking action with this powerful strategy or would like to learn about exchange opportunities, do not hesitate to contact us.

Terra West Group does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information.

Donny Rocha