It has been a while since we did a post on Section 1031 exchanges. Tax Reform eliminated the ability for using a tax-deferred exchange on personal property. For farmers in states without an income tax, this actually can result in owing less tax. Here is an example:
Jane, a Schedule F farmer trades in an old tractor (fully depreciated) for a new tractor. Trade-in value is $100,000 and the cost is $200,000. Under the old rules, there is no gain on the trade and she will have a cost basis of $100,000 on the new tractor which can be fully depreciated using bonus or Section 179 which will reduce her income and self-employment (SE) tax.
Under the new law, she has to report the trade-in value as a sale. The $100,000 gain is not subject to SE tax and she gets to fully write-off the $200,000 cost of the new tractor which reduces SE and income tax.
Now, if Jane lived in a state with an income tax, the final result will be slightly different. Federal remains the same, but in most states they do not allow bonus depreciation and Section 179 is capped at $25,000. Therefore, Jane may have to report $100,000 of gain, but only be allowed to write-off $40,000 of depreciation (Section 179 may not be allowed at all).
1031 exchanges are still allowed for real property. However, farmland contains many items of what we call Section 1245 real property. This type of property must be reinvested into Section 1245 real property to defer the gain. Farmland with no 1245 real property can be invested into any real property including apartments, mini-storages, etc. Here is an example:
Jane sells a quarter section with a grain bin for $1.5 million. The grain bin is worth $500,000. She buys another quarter section for $1.5 million. If there is no Section 1245 real property on the land, then she has to report $500,000 of gain on the grain bin (assumed it is fully depreciated). However, if there is tiling, grain bins, hog barn, etc. on the land worth at least $500,000, then no tax is owed on the exchange.
Section 1245 real property is a fairly broad category - Tiling, Wells, Grain Bins, Trees, Vines, Commodity Storage Facilities, Hog Barns, Dairy Parlors, Greenhouses, etc. Any of these can be exchanged for any of these in the list. Does not have to be exactly the same, but rather 1245 real for 1245 real.
One quirk that still remains under 1031 exchanges is that Section 179 depreciation cannot be taken on the old cost basis of the property exchanged. Since personal property exchanges are no longer allowed, this rule does not apply to personal property trade-ins. Section 179 is allowed on the full cost of the new asset. However, it will remain an issue for Section 1245 real property trades. Here is an example:
Jane, on her land sale, has basis in the grain bins of $200,000. She ends up buying farmland with another grain bin worth $500,000. She can take Section 179 on $300,000 or bonus depreciation on $500,000, but can't take Section 179 on the carryover cost basis of $200,000.
Finally, Section 1245 recapture for assets that have been previously purchased using a tax-deferred exchange can get reported incorrectly. Software sometimes does not track the amount of depreciation correctly and the final amount of 1245 gain is understated. In almost all situations, all of the gain should be 1245 gain (which is ordinary) and none of it should be Section 1231 gain (which is capital). Here is an example"
Jane owns a tractor that she originally paid $250,000 for, however, part of that was a trade of an old tractor worth $150,000, therefore on her books the net cost was only shown as $100,000. In 2020, she sells it for $175,000. It is fully depreciated and her software shows $100,000 of 1245 gain and $75,000 of 1231 gain. In fact, all of it is 1245 gain. Only if she sold the tractor for more than $250,000 would she have any 1231 gain.