Overview of the 1031 exchange

The IRC Section 1031 Exchange enables a taxpayer to sell appreciated property, purchase other “like-kind” property and defer the capital gain tax and depreciate recapture.

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Chris Nolt

To quote the tax code, IRC Section 1031 (a)(1) states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

While agricultural families often use the 1031 exchange to purchase land, many use it for investment in other types of property. A common misconception among farmers and ranchers is the “like-kind” definition means they must exchange land for other land. This is not the case.

Many agricultural families who are downsizing their operation or transitioning into retirement use the 1031 exchange to purchase other types of income-producing real estate such as office buildings, rental houses or apartment complexes. When a family sells land that has been held for many years and has a very low cost basis, the tax consequences can be significant.

If the 1031 exchange is eliminated, it would have devastating consequences for agricultural families.

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To help illustrate the tax-saving and wealth-building power of a 1031 exchange, consider this example: A married couple sells ranch land for $5 million with a cost basis of $1 million. Assuming a combined federal and state capital gain tax rate of 25 percent, they would pay approximately $1 million in taxes if they were to cash out.

If this same couple were to do a 1031 exchange on the full $5 million sale, this $1 million that would have gone to pay taxes could be invested in additional real estate. Assuming this real estate returned 7 percent per year, it would generate an additional $70,000 per year of income.

Not only would this couple benefit from the additional income the real estate generates while they are alive, if they hold the property until they die and if real estate continues to receive a step up in basis upon death, they could potentially pass several million dollars more to their heirs and their heirs may avoid the capital gain taxes on the property entirely.

Congress threatens IRC Section 1031 tax-deferred exchanges

The House Ways and Means Committee Chair, Kevin Brady, is touting the House Republican Blueprint (HRB) as a means of accomplishing comprehensive tax reform which also has the backing of Speaker of the House Paul Ryan. The Senate Finance Committee is looking at business tax integration that dovetails with the HRB goal of lowering tax rates.

Even though none of the measures mention repeal or limitation of Section 1031, it is clear from comments made by Chairman Brady and his staff that they think the immediate expensing for personal property offered in the HRB eliminates the need for 1031 exchanges. They have also stated the tax code will be rebuilt from a clean slate.

In doing so, they are hoping nobody notices the dire implications for Section 1031 until it is too late to save it. The same thing is going to happen to interest expense deductions.

The loss of Section 1031 would have a major impact on those holding appreciated real estate. Farm and ranch owners will be especially hard hit since many own properties that have been held through generations and have close to zero-cost basis.

According to a study conducted by Ernst and Young., “repeal of the 1031 exchange could cost the U.S. economy as much as $13.1 billion in lost GDP year after year. This GDP loss would also result in investment falling by $7 billion every year and would reduce income by an estimated $1.4 billion.”

A proposal from the House is expected very quickly, if not in 2016, then in the early weeks of January. Therefore, it is urgent you contact your congressman as soon as possible to express your desire to protect the 1031 exchange.

For more information, go to: Solid Rock Reality Advisors. end mark

Chris Nolt is the author of Financial Strategies For Selling A Farm Or Ranch and owner of Solid Rock Realty Advisors and Solid Rock Wealth Management, sister companies dedicated to working with families who are selling a farm or ranch and transitioning into retirement. For more information, visit Solid Rock Reality Advisors or call (800) 517-1031.

Chris Nolt