What Property Qualifies for 1031 Exchange

• November 1, 2021
• Paul Neiffer

Many farmers are considering selling their land this year due to rapid appreciation in the value or to escape any possible capital gains tax increases.  However, many of them also plan on deferring the gain into other real estate using a tax-deferred exchange under Section 1031.

This is very easy if the only property sold is raw land with no buildings or land improvements such as tiling. In this case, the farmer needs to invest the net proceeds from the sale and all of the cash proceeds transferred to the exchange facilitator.  Here is an example:

Debbie sells a quarter section for $2 million in Iowa and at closing $1.5 million is transferred to the exchange company and $500,000 of debt is paid.  She then finds land worth $2.2 million.  She rolls all of the cash into the purchase and can either pay the rest with any combination of debt or cash.

However, many parcels of land have land improvements.  This is considered to be Section 1245 real property even though it may have been fully depreciated.  In order to defer the gain, the farmer must invest in other Section 1245 property of equal or greater value to completely defer the gain.  Let’s look at an example:

Debbie had tiling worth $400,000 on her sale.  If the new land has tiling, hog barns, dairy parlor, grain bins, etc. of at least $400,000 of value, she will defer the gain.  It it is less than $400,000, then the difference will be taxable to Debbie.

Now, in some cases where there is either no state income tax or the state follows federal on 100% bonus depreciation we would prefer the gain not be deferred.  This is because the gain is not subject to self-employment tax, whereas the purchased Section 1245 property can be fully depreciated and reduce SE tax.  Here is an example:

Debbie sells the tile outside of the exchange and reports a $400,000 ordinary gain.  She purchases $500,000 of grain bins which reduces her Schedule F income by $500,000.

However, if the farmer sells land with Section 1245 real property and purchases real estate with no Section 1245 real property, then the gain will be fully realized and cannot be deferred.  Plus it will be taxed as ordinary income at higher rates.  Here is an example:

Debbie only purchases land with no Section 1245 real property.  She will defer the gain on the land, but will be required to report $400,000 of ordinary gain on the tile.

As you can see, a 1031 exchange dealing with farm real estate can be more complicated than an exchange of an apartment building or other non-farm property.  Always discuss any 1031 exchange with your advisor before signing any documents related to the sale.  One trap is that many farmers assume they have 180 days to complete the exchange, but if they receive the cash from the sale, they have blown the exchange.  You are not allowed to get cash and have it be fully deferred.

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