There are many reasons why dairy farmers consider selling real estate. Some sales are the result of condemnation or forced sale, while others are due to the death of the landowner.
Still others are because a landowner wants to cash out of a piece of property or put his money elsewhere.
Regardless of the reason, the landowner faces a potential tax liability if the proceeds of the sale are greater than the undepreciated basis of the property. To reduce or eliminate these obligations, a solution to be considered is the use of a like-kind exchange.
In this article, we’ll take a closer look at how a like-kind exchange (also known as a 1031 exchange) can help your farm reduce its tax burden when selling real estate.
1031 exchange basics
The Internal Revenue Code Section 1031 provides the steps that must be followed in order to qualify the sale as a like-kind exchange. This section of the code, if followed, will allow a seller of real estate to transfer the proceeds to another like-kind piece of property without recognizing taxable gain.
The taxpayer can, with the use of financing, acquire a large or more expensive piece of property using the equity in the first property as a down payment. Multiple parcels can be combined into one larger parcel, or a more expensive parcel can be exchanged for multiple smaller parcels.
To qualify for a 1031 exchange, the taxpayer first needs to have a realized gain. This, of course, means that what he is receiving from the sale is more than what he has invested in the property less depreciation that he has already taken on his current and previous tax returns.
This is called the undepreciated basis. If property is received by inheritance, the basis is the fair market value on the date of death. If the property is received by a gift after 1977, the basis is the undepreciated basis of the gift giver at the time of the gift.
If there is no gain, there is no need to go through the paperwork or expense of a 1031 exchange. If there is a taxable gain, then the taxpayer needs to calculate the potential tax liability to decide if the tax savings is enough to justify the cost of the 1031. When calculating tax liability, do not forget that large capital gains will cause an alternative tax to be assessed, which would exceed the capital gains tax on the federal tax return.
Three considerations for a successful 1031 exchange
Once it is determined that the taxpayer has a realized gain, the object of executing a 1031 exchange is to keep from recognizing a taxable gain, which would result in a tax liability. There are three main concerns that must be addressed to properly execute a 1031 exchange. Failure to properly follow these rules will result in taxes being owed, and there is no way to correct them.
The first is custody of the money received. It cannot be received by the seller but must be transferred at closing to a qualified intermediary (QI). It is important to make sure that the firm selected as a QI is experienced and financially sound. There is no federal oversight of QIs or how they invest your money while it is being held.
Banks sometimes act as QIs, but make sure they are experienced because their error will cost you in the form of taxes. There are firms that specialize in 1031 exchanges and are reputable and will safeguard your assets. These are the firms you want to consider.
If you have debt associated with the disposed property that is paid off in the transaction, the payoff amount is counted as “boot” and is therefore taxed. The only way to keep this from being taxed is to assume debt on the purchase of the new property or add cash to the purchase in the amount that was paid off.
One way to possibly get cash out of the transaction is to borrow the money secured by the real estate before selling it. Then the loan can be transferred to the new property without being taxable. Or, once the transaction is complete, you can use the acquired property to secure financing. It is important to seek experienced professional advice to ensure that you do not end up owing taxes.
The second important consideration is that the property you are trading for is considered “like kind” by the Internal Revenue Service. An experienced certified public accountant, enrolled agent or qualified intermediary can check into this for you. Property that is held for “productive use” in a trade of business or as investment property can be exchanged for any other properties that are used for productive use in a trade, business or as investment property.
The property exchanged can be unimproved real estate, buildings, improved property, leaseholds with more than 30 years left or improvements to received property to be completed after the property is acquired. The important thing to remember when doing a 1031 exchange is that custody of the money must remain with a third party, and all transfers of the proceeds are directly from the QI.Like-kind property cannot be received from related parties including individuals, partnerships, LLCs or corporations in which the person selling the property or their family members have an interest.
The last important consideration is time. The clock starts running at the closing of the disposed property. The seller has 45 days before or after the closing date to identify the property to be acquired. Once the property is identified, that property must be acquired within 180 days of the original closing. “Acquired” means the sale is closed and the title to the property is transferred to the individual doing the 1031 exchange.
If construction is involved, it must be completed within the 180 days. There is no extension and no exception to these rules. If they are violated, then taxes are owed. It is important that you understand these dates and monitor them closely. The amount of taxes owed can be large, and missing the date could be catastrophic.
Additional food for thought
It is not required that you do a total exchange under Section 1031, but if you receive any boot in the form of cash, non-like-kind property or repayment of debt, it is taxable to the extent of gain realized. If, at the end of the 180-day period, you have not utilized all the money with the QI, you will receive the money, and it will be taxable as boot. Many taxpayers choose this option and cash out part of the sale proceeds. They can be received at closing or after the 180-day period after closing.
There are many more rules for identifying and closing on properties. For example, the property acquired can be a partial interest in tenant-in-common property. Some firms offer tenant-in-common programs that qualify for 1031 exchanges. These programs can provide regular income without management responsibilities.
1031 exchanges offer great options for dairy farmers
Section 1031 exchanges can save hundreds of thousands of dollars in state and federal income taxes; they can also allow the exchange of properties without tax liabilities. The rules for 1031 exchanges are complicated and inflexible.
Therefore, if you are considering a 1031 exchange for your dairy operation, it is important that you find a professional who is experienced and understands those rules. You will also need a QI who is experienced, financially sound and capable of guiding you through the process. PD
Jeff Baker holds a bachelor’s degree from Purdue University and a master’s degree in financial analysis from the same institution. With more than 30 years of experience in private practice, Jeff helps farmers navigate the often confusing world of farm tax accounting.
Readers should not act upon the presented content or information without first seeking appropriate professional advice.
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Jeff Baker
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- Baker Retirement and Wealth Management
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