Farm and Ranch Exchanges
Section 1031 allows investors to defer capital gains on the sale of a qualified property if it is exchanged for like-kind property. In general, there are very flexible IRS rules to accomplish the 1031 exchange.
The typical exchange occurs for many reasons. It can be a wealth building strategy by deferring taxes or defeating taxes. It is a huge benefit for those re-locating operations. Also significant is its use in diversification, estate planning and generational transitions. Step-up in basis rules make your tax deferral under § 1031 permanent.
Many ranch exchanges are multiple asset exchanges consisting of both real property and personal property. Allocation of cost between the different asset types becomes critical. The property may also include a principal residence which could fall under the § 121 exclusion rules. Maximizing this benefit is an-other key element in a good ranch transaction.
Real property exchanges have more flexibility in determining what is like-kind. Examples that are interchangeable include: land, buildings, commercial, residential, conservation easements, perpetual water rights, perpetual easements, mineral rights, long term leases, royalty interests, pipeline easements.
Personal property exchanges are hugely beneficial whenever largely depreciated assets such as equipment, livestock, wildlife or vehicles are including as part of a ranch sale or in conjunction with a sale. Even if a ranching or farming operation is discontinued, a strategy of buying replacement equipment for a leasing business is a great opportunity.
Livestock and wildlife are personal property. Consequently, like-kind requirements are much stricter. Only breeding stock qualifies. Steers and stocker and feeder calves are considered inventory and do not qualify. Males are like-kind only to other males of the species, etc. Replacement identification and timing can become challenging. In drought areas, consider other deferral options under drought relief and livestock sales – Notice 2006-82. (See National Drought Mitigation Center)
Agriculture exchanges could include irrigation equipment (is a fixed pivot real property or personal property?), cattle feeders, farm and ranch tools, and live-stock handling equipment. A complex classification system requires close planning with your accountant to determine like-kind categories. Use NAICS classifications as a guide. The sale of equipment with high cash value but low or zero cost basis creates opportunity for tax deferral. It may be advisable to create a bill of sale for personal property rather than include them in a real estate contract. The allocation of values could create tension between parties.
Reverse exchanges allow flexible purchase strategies but by nature are more complex and expensive. If cash is not available, financing of replacement property requires knowledgeable lenders. Possible operational issues include farm program payments and eligibility, and limitations on use of entities. Closing deadline is still 180 days. Non-safe harbor reverse exchanges (longer than 180 days) are possible but require considerable planning, exposes parties to in-creased risk, and performed by only a very few exchange accommodators.
Interplay of Section 1031 with Section 1033 exchanges. Section 1033(g) uses a “similar in use” standard to qualify replacement property. This requires unimproved land be replaced with unimproved land, the transition to improved property is not similar-in-use. To use the “like-kind” standards for real property, one must substitute 1031 rules for 1033 rules, thus the taxpayer is limited to a 180 replacement period rather than the “up to” 3 year period under 1033.