Planning to trade up or out some farmland this year? Consult your tax adviser first. The Tax Cuts and Jobs Act made Section 1031 Tax-Deferred Exchanges (also known as like-kind exchanges) more complex to execute.
“Under the new tax law, trading farmland is allowed using a 1031 exchange to defer the tax,” says Paul Neiffer, a CPA and principal at CliftonLarsonAllen and author of the blog “The Farm CPA.” “However, in order for it to be completely tax-free, it usually must include only land or items that constitute real estate.”
So, if your land includes items that classify as Section 1245 real property, the process becomes more complicated. These are depreciable items such as tiling, wells, irrigation pivots, fences, etc., and they will be fully taxable—even if you trade the property for other farmland, Neiffer explains. However, if the farmland you are exchanging for includes these same items at equal to or greater than what you are selling, the income tax effect will likely be a wash.
Listen to Neiffer discuss the logistics of doing a 1031 exchange with Davis Michelson on AgriTalk:
For example, Farmer Joe sells farmland worth $1 million. He purchased it for $100,000 several years ago. If Joe sells it for cash, the gain is $900,000 and subject to capital gains taxes. However, if he trades it for other farmland worth $1 million, there is no tax due.
Now, let’s assume Joe put tile into the land at a cost of $100,000 and when the sale is done, the value is still $100,000. This means the farmland value is $900,000, which can be rolled over tax-free into the new land.
However, Joe will now owe ordinary tax on the $100,000 tile sale. This gain will be eligible for the new 20% Section 199A deduction (subject to possible limitations).
If the new farmland has tile worth $100,000, Joe can roll over the land and tile gain tax-free since the new land purchase has at least $100,000 of Section 1245 real property (i.e. the tiling).
“If you're a farmer, and you do have certain items on that ground that aren’t pure land, you really need to discuss that with your tax advisor before you go ahead and enter into any type of exchange,” Neiffer says. “There's lots of things that sometimes we can do to help mitigate that tax liability. The worst thing you can do is do an exchange and then come in during tax time and dump it in your advisor’s lap and hope that they can pick a tax liability.”
The process can also be a bit cumbersome and lengthy. “Anytime you're doing a tax-deferred exchange, you have to use what's called a facilitator,” Neiffer explains. “That means when you sell the property, you have a third party that gets involved and will actually hold the funds and purchase the replacement property.”
Timing is important with 1031 exchanges, Neiffer says. Farmers only have 45 days to identify the piece of property that they want to acquire. Then, they only have 180 days to acquire the property.
“When you’re dealing with real estate 180 days is not that long,” Neiffer says.
Read Paul’s AgWeb blog: The Farm CPA