ABC'S of 1031 Tax-Deferred Exchanges
An Overview of IRS Revenue Procedure 2002-22

By: Louis J. Rogers, Attorney At Law
(804) 771-9567 – lrogers@hirschlerfleischer.com

A. Introduction

Did you know that you can sell a portion of your family farm without paying federal and state income taxes? Did you know that you can sell conservation easements, development rights, water rights, and the like without paying federal and state income taxes? Since 1921, Section 1031 of the Internal Revenue Code has permitted farmers (and other owners of investment and trade or business property) to defer the gain on the sale of property by acquiring like kind replacement property.

B. Basics. A summary of Section 1031 follows.

1. Investment or Business Property. Your current property (the "relinquished property") must be held for investment or use in a trade or business. Farm property generally qualifies.

2. Like Kind. The replacement property must be of "like kind" to your farm. Virtually any kind of real estate will satisfy the like kind requirement, provided it is not a principal residence, second home or other personal use property. Accordingly, all sorts of investment real estate should qualify as replacement property, for example, apartments, office buildings and shopping centers. However, farm equipment (for example, tractors) is not like kind to real estate and can only be exchanged for other like kind equipment.

3. Simultaneous vs. Deferred Exchanges. You may structure a simultaneous exchange where you close on the farm and the replacement property at the same time. Alternatively, you may structure a deferred exchange where you close on the farm today and acquire the replacement in the future. Most exchanges are structured as deferred exchanges. In a deferred exchange, the replacement property must be identified within 45 days of closing the farm and you must acquire the replacement property within 180 days of closing the farm.

4. Safe Harbor for use of Qualified Intermediary. In most deferred exchanges, the taxpayer engages a "qualified intermediary" who prepares an exchange agreement and holds the net proceeds from the relinquished property in an exchange escrow account pending closing of the replacement property. The Treasury Regulations provide a "safe harbor" for use of a qualified intermediary that protects the taxpayer from being in constructive receipt of the funds in the exchange escrow even though the qualified intermediary is required to disburse the funds at the taxpayer's direction. The taxpayer generally is entitled to interest earned on the escrow (and will be taxable on the interest earned).

5. Liability Rules. If your farm is encumbered by a mortgage or other liability, you will be required to reinvest the net proceeds from the sale in qualifying replacement property. In addition, the replacement property must be encumbered by an equal or greater liability (or you may use other funds to reduce the amount of liabilities on the replacement property). Further, you can "trade up" by leveraging the replacement property. Such a trade up provides new tax basis which may generate depreciation deductions to help offset taxable income generated by the replacement property.

6. Conclusion. There is no downside to structuring the sale of your farm as an exchange – if you fail to identify or acquire qualifying replacement property, the funds in the escrow will be returned to you and generally with interest. Hence, you may consider this simply an option to exchange.

C. Solution to Farmers' Cash Needs.

By structuring the sale of excess farmland as an exchange, you can generate cash flow to provide for current needs and, possibly, save for retirement. Your earning power will be increased by the return on the tax that otherwise would have been paid in federal and state taxes. In addition, you can exchange non-income producing land for replacement property that generates cash flow.

1. Example of Use of 1031 to Generate Cash Flow. For example, assume you have no basis in a parcel of farmland that a developer would like to purchase for $1 million. On sale of the property, you would owe a 20% capital gains tax and 5_% (Virginia) state income tax. Accordingly, you would owe approximately $250,000 in combined taxes, resulting in approximately $750,000 of net after tax proceeds. Alternatively, if you were to exchange the parcel as described above, you could reinvest $1 million in qualifying replacement property. Assuming that the replacement property generates an 8% net return, by structuring an exchange you would have an additional $20,000 cash flow per year for as long as you own the replacement property. Moreover, if the farmland was not generating any net income, you would have an additional $80,000 of cash flow per year for as long as you own the replacement property (and you can structure another exchange when the time comes to sell the replacement property). This is o ne of the only ways "land poor" farmers can provide for their current and future needs.

2. Example of Trade Up. In addition, you may wish to "trade up" by incurring debt. If you were to acquire $2 million of replacement property with $1 million of debt (which may be nonrecourse), your earning power would be increased through the power of leverage. Additionally, you may be able to diversify through the use of leverage -- meaning you may be able to acquire more property of a different type, with different tenants, and possibly in a different location, which may help minimize the risk of having only a single replacement property ("all your eggs in one basket").

3. Tenant in Common Replacement Property. You may acquire an undivided tenant in common ("TIC") interest in a larger property. These TIC interests are structured to permit investors to acquire a small piece of a larger property with better tenants and property managers than they could have afforded on their own. For many people, a TIC replacement property is the perfect solution to their needs for cash flow, capital appreciation, and desire not to actively manage property. Also, you may acquire a TIC interest in a number of properties to create a diversified real estate portfolio.

D. Conclusion.

In conclusion, you should consider the exchange option whenever the opportunity presents itself to sell a portion of your farm, a conservation easements, development rights, water rights or the like associated with your farm. For further information, contact the author at (804) 771-9567 or lrogers@hirschlerfleischer.com.