During the past 10 years of my public accounting profession, I have noticed a trend among the farming clients I serve. This trend validates the old cliché “land rich, cash poor.” This article discusses an option that can change this cliché to “land rich, cash more.”
The underlying idea is to take a piece of land that is not generating sufficient or any cash flows and trade it up for land that will produce additional cash flow.
The IRS will actually assist in accomplishing this transaction completely tax-free via one of the most friendly areas of tax law, known as §1031 like-kind exchanges.
Like-kind exchanges allow you to avoid recognizing any gain on the sale of your existing property if you use those proceeds to purchase another piece of property. By trading up, you remain land rich with a property that now produces more cash flow.
For most farming clients, the idea of selling any of their land would bring the conversation to an end fairly quickly. However, the idea of selling a few land parcels and replacing those with another piece of real property can be a much more acceptable idea.
To present this, let’s consider a couple options in finding a piece of replacement property.
When it comes to §1031 like-kind exchanges, exchanging real property is the most flexible application. Tax law allows you to exchange unimproved real estate for improved real estate or vice versa because all real property meets the definition of being like-kind.
What kind of properties can you consider targeting to help create more cash flow? I’d first suggest looking into acquiring rental properties.
Rental properties are typically either going to be commercial or residential. These properties can be anywhere in the U.S., so don’t box yourself into thinking there is no need for commercial or rental properties in the area you live.
Rental properties have proven to provide a consistent source of cash flow while retaining value or even experiencing appreciation in the underlying value of real property.
Another option would be to sell or trade multiple parcels of lower-valued properties for one higher-valued property in anticipation of economic growth due to a favorable location.
The goal of acquiring this higher-valued property would be that this property would start to produce positive cash flows sooner than later.
This property could be tagged for long-term land leases (i.e., 40-year land lease) for commercial developments, thus becoming a very attractive investment property able to produce the sustainable cash flows desired.
Again, when targeting a better piece of cash-producing property, the tax law is very friendly in allowing any real property to be exchanged tax-free for any other piece of real property.
Let’s go over some highlights of doing a like-kind exchange transaction with real property.
1. The property must be held for use in a trade or business or for investment purposes.
2. Due to timing issues of selling the old property and buying the new, use of a qualified intermediary (QI) will often be necessary. A QI will hold the sale proceeds from the old land in an escrow account until closing on the purchase of the new land.
You can never take possession of the cash proceeds from the sale of the old land in order to meet the tax-free exchange requirements, thus the need of the QI.
3. Once the old land is sold, you have 45 days to identify potential replacement properties and 180 days to actually purchase new property.
4. If the exchange is between related-party taxpayers and either of those parties dispose of their property within two years, then the tax-free exchange becomes taxable at that time.
5. Being relieved of any debt or receiving cash during an exchange can cause recognition of taxable income on these items.
With the help of friendly tax law allowing for tax-free exchanges, you may find that you have some stagnant cash-producing land parcels that are ready to be traded up for a property that will produce consistent cash flows, helping you sustain your farming operations. PD
Mitchell Moncur
CPA
