Those looking to diversify their investment portfolios while deferring taxes can turn to 1031 exchanges, a viable and popular strategy. This approach allows you to exchange properties without incurring a sale, making you eligible to defer capital gains taxes. For farmland owners, this can be a valuable tax-saving strategy. However, specific 1031 exchange farmland rules apply. Not all aspects of a farm qualify, making such a transaction more complex than exchanging apartment complexes, for example.
In this blog post, Realized 1031 explores this process and how you can successfully conduct it to defer farmland capital gains tax.
Yes, farmlands are eligible for 1031 exchanges. As a refresher, the like-kind swap has a few rules that limit the kind of assets you can exchange. These assets must be real property and must be used for investment or business use. Given how farmlands typically satisfy both requirements, this makes them eligible for a 1031 exchange.
What do we consider farmland? In the context of investment, farmland is a real estate asset class consisting of property used for growing crops, raising livestock, and logging. Given these operations, farmland is a productive property that generates income. However, not all aspects of farmland are held for productive use or even real property, complicating their eligibility.
According to IRS regulations, real property includes land, permanent structures, and certain land improvements and rights. Farmland usually includes these elements, such as arable land and buildings for farming operations. However, you will also find other types of assets, such as primary residences, livestock, and farming equipment. These may still be included in a sale, but the gains from these assets are usually ineligible for a 1031 exchange.
When undergoing a 1031 exchange for farmland, one of the main concerns is whether or not the primary residence qualifies. This asset is real property, but it doesn’t satisfy one other 1031 exchange rule: the asset must be held for business or investment use. As such, the primary residence does not qualify for the like-kind swap. Other similar properties, such as grain storage facilities, barns, and agricultural warehouses, qualify because their usage demonstrates clear separation from the primary residence.
Given this ineligibility, selling the primary residence along with the farmhouse will result in capital gains farmland tax. Thankfully, you can take advantage of the Section 121 Exclusion to potentially reduce or eliminate your tax burden. If your primary residence qualifies based on Section 121 rules, you can enjoy $250,000 of the gain excluded from your taxable income if you’re single, or $500,000 if you’re married filing jointly.
Farmland often contains assets, aside from the primary residence, that do not qualify for a 1031 exchange because they are classified as personal property rather than real estate. These may include the following.
Since these assets are not considered real property, their sale may be subject to capital gains or ordinary income tax. If you’re selling a farm with both real and personal property, it may be necessary to allocate values separately in the transaction to ensure the 1031 exchange only applies to the qualifying land and buildings.
Another source of complication when exchanging farmland is if the property has associated water or mineral rights. For these types of real property, eligibility can depend on state laws, which the IRS follows.
Mineral rights (such as oil, gas, or coal deposits) may be treated as real property if they are attached to the land and transferred with it. In addition, mineral rights severed from surface rights can be eligible, but some states will treat these as personal property. Mineral leases and royalty interests, which represent temporary ownership of properties or income, are considered personal property in most states. This categorization disqualifies the latter rights for a 1031 exchange.
On a similar note, water rights can be exchanged if the state classifies them as real property. This usually happens when the water rights are attached to the land and considered an appurtenance.
To ensure compliance, farmland owners should confirm how their state categorizes these rights before structuring an exchange. If mineral or water rights are not eligible, the taxable portion of the sale should be accounted for separately to avoid IRS penalties.
Exchanging farmland follows the same process and deadlines as traditional 1031 exchanges. The biggest difference here is the presence of real, non-real, and non-like-kind property during the sale. As such, calculating how much of your farmland qualifies for a 1031 exchange requires categorizing your asset into these three types.
The next step is finding a proper replacement property based on IRS requirements. The replacement property must be of equal or greater value than the portion of farmland being exchanged. If the identified asset has less value than your farmland, you may end up with boot, which is taxable. Thankfully, there you can combine multiple replacement properties to match the full value of your farmland thanks to stipulations like the 200% rule.
For the non-exchangeable portions of the farmland, these will need to be taxed separately. You will need to work with a tax advisor or accountant to properly identify these ineligible assets, ensure proper filing, and potentially minimize liability.
Executing a 1031 exchange for farmland requires careful planning to ensure compliance with IRS rules and maintain your tax-deferred status. Our most important recommendation would be to engage with a tax professional or 1031 exchange expert to gain guidance and access to resources for the exchange.
We can help you separate your exchangeable and non-exchangeable assets to minimize the chances of disqualification. Plus, experts like us can help you understand specific state rules for water and mineral rights. Having these insights helps you prepare for any tax implications, especially with regard to capital gains taxes.
Exchanging farmland is a great strategy that allows you to diversify into other assets without the burden of capital gains taxes. While the process of swapping farmland for another like-kind property is similar to a traditional exchange, complications arise when there are non-eligible assets within the farmland. These include primary residences, livestock, and temporary ownership rights of minerals or water resources. As such, it’s crucial to work with tax experts or 1031 exchange professionals to segregate eligible and ineligible assets and ensure tax deferral benefits.
For more details about exchanging farmland, we’re here to help. Contact Realized 1031 today.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://corporatefinanceinstitute.com/resources/commercial-real-estate/farmland/
https://www.investopedia.com/terms/r/real-property.asp