In my 26 years as a financial advisor to agriculture families, I’ve learned that farmers and ranchers hate paying annual income taxes. Sadly, however, many fail to avoid paying tax on the biggest tax event of their lives – when they sell their farm or ranch.
If you sell land that has appreciated in value and receive cash from the sale, you will pay taxes on the difference between your net sale proceeds and your cost basis in the property. This tax may range from 20% of the gain in your property to over 50% of the gain in your property, depending on the state you live in and how the property is owned.
In 2013, capital gain tax rates increased to a maximum federal rate of 20%. In addition to federal capital gain taxes, most states have a tax that will be imposed on the recognition of capital gains. Also, if you are not actively engaged in running your farm/ranch, you may be subject to the 3.8% Medicare Surtax (Obama Care Tax) on the sale of your land. It is not uncommon for a family selling their farm or ranch to pay 25% or more of the value of their property in taxes.
Fortunately, the IRC Section 1031 Exchange allows a taxpayer to sell appreciated real estate and defer taxes on the sale by exchanging into other real estate. To quote the tax code, IRC Section 1031 states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.
I often speak with ag producers who mistakenly think “like-kind” means they must exchange land for other land. This is not the case. Fortunately, the definition of “like-kind” property is very broad. A taxpayer may exchange land into other types of property such as office buildings, rental houses, apartment complexes, storage units etc.
Saving taxes with a 1031 exchange allows you to purchase more real estate. This enables you to accumulate greater wealth. If you sell $1 million of land for example with a cost basis of $100,000, you will likely save between $180,000 to $260,000 in taxes by performing a 1031 exchange.
If you saved $200,000 on taxes and you earn a 7% return on your replacement property, you would generate an additional $140,000 per year of income by performing a 1031 exchange. If you lived for 20 years, the income and appreciation from this additional real estate could amount to a small fortune.
Taxes are deferred with a 1031 exchange until you later sell the property in a taxable transaction. However, if you hold real estate until you die, your heirs receive a “stepped-up” basis to the fair market value of the property when you die. This means that it is possible to not only defer tax on the sale of appreciated property but to avoid the income tax altogether.
There are rules you must follow for completing a 1031 exchange. One requirement is that you must identify your “replacement property” within 45 days of closing on the sale of your “relinquished property”. Second, you must close on the sale of your replacement property within 180 days of closing on the sale of your relinquished property.