1031 Tax-Deferred Exchange Does Not Always Defer All Taxes!
Feb 18, 2013
With farmland prices at or near an all-time high, many farmers are considering selling their farmland and rolling over the gain into other real estate on a tax-deferred basis using a Section 1031 tax-deferred exchange. Under these rules, the farmer has 45 days from the date of closing (not when you sign the offer) to identify the real estate they wish to buy (usually up to three can be identified without any issue) and then another 135 days or 180 days total to finally close on this replacement property.
The farmer must reinvest the net selling price of the property sold in the purchase of the new property. For example, if land is sold for $1.5 million with $100,000 of selling costs and $400,000 of debt paid off, the farmer must reinvest $1.4 million and at least $1 million of cash. They can pay more than that in cash, but the minimum is the $1 million.
If the farmer meets these rules, they automatically assume there will be no tax due, however, certain things can spring a nasty surprise at tax time.
First, the sale of farmland may also involve the sale of personal property such as wells, fences, grain bins, etc. that are subject to Section 1245 recapture. Farm land can normally be reinvested into any other real estate, however, personal property has greater restrictions on what qualifies. If the farmer sold their $1.5 of farmland, but $300,000 of this was personal property that was not acquired for the same kind, then the farmer will have $300,000 of ordinary income that could easily cost $100,000 without having any cash to pay for it.
Second, if the owner of the property lives in a state separate from their land holdings, the whole gain may be subject to state income taxes. Many states require any replacement property to be reinvested in the state of sale. If not, the state will assess tax when the reinvestment property occurs out of state. For example, assume a Missouri resident owns the $1.5 million farm in Oregon and rolls over the farm land into an apartment building in Missouri. Assuming a $1 million gain, this whole amount will be subject to Oregon tax of about $100,000, again with no cash to pay for it.
Third, many taxpayers assume that these day requirements automatically roll over to the next business day which is not correct for Section 1031 purposes. You must count the actual days and if the 45 day or 180 day date falls on a Saturday, Sunday or Holiday, you must make sure to perform the required task BEFORE that date.
This can be a very complicated transaction and it is very important to review this with a tax advisor that understands these rules.