ABC’S OF 1031 EXCHANGES

 

(How to Exchange 1031 Properties, Save

Tax Dollars, and Enhance Your Cash Flow)

 

by

 

Louis J. Rogers

Hirschler Fleischer

701 East Byrd Street

Richmond, VA 23219

P.O. Box 500

Richmond, VA  23204-0500

(804) 771-9567

 

 

 

 

 

 

Introduction. 

 

Did you know that you can sell a portion of your family farm without paying federal and state income taxes?  Did you know that you can sell conservation easements, development rights, water rights, and the like without paying federal and state income taxes?  Since 1921, Section 1031 of the Internal Revenue Code has permitted farmers (and other owners of investment and trade or business property) to defer the gain on the sale of property by acquiring 1031 properties (also known as “like kind properties” and “replacement properties”). 

 

Basics.

 

1. Investment or Business Property. Your current property (the “relinquished property”) must be held for investment or use in a trade or business.  Farm property generally qualifies.

 

2. Like Kind.  The 1031 properties (one may exchange multiple or single 1031 properties) must be of “like kind” to your farm.  Virtually any kind of real estate will satisfy the like kind requirement, provided it is not a principal residence, second home or other personal use property.  Accordingly, all sorts of investment real estate should qualify as 1031 properties, for example, apartments, office buildings and shopping centers. However, farm equipment (for example, tractors) is not like kind to real estate and can only be exchanged for other like kind equipment.  (In addition, timber and certain mineral interests may be exchanged under Section 1031 but those topics are beyond the scope of this article.)

 

3. Simultaneous vs. Deferred Exchanges of 1031 Properties.  You may structure a simultaneous 1031 exchange  where you close on the farm and the 1031 property (or multiple 1031 properties) at the same time.  Alternatively, you may structure a deferred 1031 exchange where you close on the farm today and acquire the 1031 property (or multiple 1031 properties) in the future.  Most exchanges are structured as deferred exchanges.  In a deferred exchange, the 1031 properties must be identified within 45 days of closing the farm and you must acquire the 1031 properties within 180 days of closing the farm.

 

4. Safe Harbor to Exchange 1031 Properties.  In most deferred exchanges, the taxpayer engages a “qualified intermediary” who prepares an exchange agreement and holds the net proceeds from the relinquished property in an exchange escrow account pending closing of the 1031 properties.  The Treasury Regulations provide a “safe harbor” for use of a qualified intermediary that protects the taxpayer from being in constructive receipt of the funds in the exchange escrow even though the qualified intermediary is required to disburse the funds at the taxpayer’s direction. The taxpayer generally is entitled to interest earned on the escrow (and will be taxed on the interest earned). 

 

5. Liability Rules.  If your farm is encumbered by a mortgage or other liability, you will be required to reinvest the net proceeds from the sale in qualifying 1031 properties.  In addition the 1031 properties must be encumbered by an equal or greater liability (or you may use other funds to reduce the amount of liabilities on the 1031 properties).  Further, you can “trade up” by leveraging the 1031 properties.  Such a trade up provides new tax basis which may generate depreciation deductions to help offset taxable income generated by the 1031 properties.

 

6. Conclusion.  There is no downside to structuring the sale of your farm as an exchange – if you fail to identify or acquire qualifying 1031 properties, the funds in the escrow will be returned to you and generally with interest.  Hence, you may consider this simply an option to exchange.

 

Solution to Farmers’ Cash Needs. 

 

By structuring the sale of excess farmland as an exchange of 1031 properties, you can generate cash flow to provide for current needs and, possibly, save for retirement.  Your earning power will be increased by the return on the tax that otherwise would have been paid in federal and state taxes.  In addition, you can exchange non-income producing land for 1031 properties that generates cash flow.

 

1. Example of Use of 1031 to Generate Cash Flow.  For example, assume you have no basis in a parcel of farmland that a developer would like to purchase for $1 million.  On sale of the property, you would owe a 20% capital gains tax and 5¾% (Virginia) state income tax.  Accordingly, you would owe approximately $250,000 in combined taxes, resulting in approximately $750,000 of net after tax proceeds.  Alternatively, if you were to exchange the parcel as described above, you could reinvest $1 million in qualifying 1031 properties.  Assuming that the 1031 properties generate an 8% net return, by structuring an exchange you would have an additional $20,000 cash flow per year for as long as you own the 1031 properties.  Moreover, if the farmland was not generating any net income, you would have an additional $80,000 of cash flow per year for as long as you own the 1031 properties (and you can structure another exchange when the time comes to sell the 1031 properties).  This is one of the only ways “land poor” farmers can provide for their current and future needs.

 

2. Example of Trade Up.  In addition, you may wish to “trade up” by incurring debt.  If you were to acquire $2 million of 1031 properties with $1 million of debt (which may be nonrecourse), your earning power would be increased through the power of leverage.  Additionally, you may be able to diversify through the use of leverage – meaning you may be able to acquire more 1031 properties of a different type, with different tenants, and possibly in a different location, which may help minimize the risk of having only a single 1031 property  (“all your eggs in one basket”).

 

3. Tenant in Common 1031 Properties.  You may acquire an undivided tenant in common (“TIC”) interest in a larger 1031 property.  These TIC interests are structured to permit investors to acquire a small piece of a larger 1031 property with better tenants and property managers than they could have afforded on their own.  For many people, a TIC 1031 property is the perfect solution to their needs for cash flow, capital appreciation, and desire not to actively manage property.  Also, you may acquire a TIC interest in a number of 1031 properties to create a diversified real estate portfolio.

 

Conclusion. 

 

In conclusion, you should consider the exchange option whenever the opportunity presents itself to sell a portion of your farm, a conservation easements, development rights, water rights or the like associated with your farm.  For further information, contact the author at (804) 771-9567 or lrogers@hirschlerfleischer.com.

 

Louis J. Rogers has a national practice specializing in real estate taxation, Section 1031 ex­changes, REITs, and real estate syndications.  When not practicing law, Rogers enjoys working on his Hanover County horse farm.