Recently, I had a taxpayer call me about the sale of some farm land. The taxpayer had sold 80 acres for $960,000 that they had inherited from his mother about 20 years ago. The tax basis in the property was about $150,000 so they were facing an $800,000 long-term capital gain which would cost them about $175,000 in federal and state income taxes.
The taxpayer indicated they had rolled the gain into other real estate costing about a $1 million and wondered how the rollover gain would affect the basis of their new real estate investment. Many of you probably can guess what my next question was. "Did you receive the cash and then buy the real estate?" To which, the taxpayer said "Yes, we received the cash, but we bought the real estate within 180 days of selling the land".
A Section 1031 tax-deferred exchange is a very valuable tax tool to help reduce your income taxes when selling farm land or other investment properties. However, there are many rules that must be followed and if you fail one of these rules, it can blow the whole exchange. In order for an exchange to be valid, the cash must from the sale must not be in the hands of the seller. Even if you reinvest the cash into other real estate within the 180 day window, the fact that you had the cash or had access to the cash makes the whole sale taxable.
In order to prevent this from happening, you must use some type of facilitator to handle the sale and the related purchase of your replacement real estate. They will step into the "shoes" of the exchanger and hold the funds until the new real estate is bought. Without this facilitator, most exchanges would be taxable (there are cases of where you can do a direct exchange such as farm equipment with a dealer, however, most real estate exchanges require a facilitator).
It was not fun for me to relay this information to the taxpayer, but this could have been prevented by them calling their tax advisor before going through with the sale. If you are anticipating a sale of real estate and want to defer the gain, always discuss this with your tax advisor before closing the sale. You can usually sign the purchase and sales agreement, but do not close it without getting a facilitator involved.
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