Farmland can be eligible under Section 1031, but calculating which gains can be deferred, and which cannot, can be complicated.
Section 1031 like-kind exchanges allow for the deferral of capital gains taxes and certain other taxes on the sale of business or investment property through the purchase of like-kind property. But some property is used for both business and personal use, while other sales involve both real property and non-real property. How does Section 1031 apply to those situations?
Farmland is a perfect example because it can include business real property, non-business real property, and other types of property and assets. Understanding how these elements are treated by Section 1031 is the key to maximizing tax deferral without misclassifying anything and ending up with an unexpectedly large tax bill.
Can farmland be used in a 1031 exchange?
In general, any property used for business or investment use is considered to be qualifying exchange property. For farmland, that means the portion of the farmland that is used for business can be included in a 1031 exchange.
If not all of the farmland is used for business, it won’t be so simple. For many farm owners, part of their property is used for business (i.e. cultivating crops or raising livestock and other animals for business purposes) while the rest is used as a primary residence.
What to do about a residence on a farm property
If you live on the property that also contains your farmland business, then the portion of the property that contains your residence does not qualify under Section 1031 and can’t be included in your 1031 exchange. There are other tax provisions, such as Section 121, to assist when it comes to gains related to your primary residence. For more information, read our blog on Section 121. It is important to determine the value of each portion of the farmland property so you understand how much of the proceeds will need to be reinvested via the 1031 exchange and how the balance of proceeds should be handled.
When exchanging INTO farmland property, any gains used to purchase the residence portion could be taxable. As an example, imagine you sold a $1 million business property and chose to acquire a $1 million farm property that included a $300,000 residence where you planned to live. If you applied the full $1 million toward the farmland, you would end up with boot in your exchange, as the business portion would only be valued at $700,000. To avoid a boot, you could add a second replacement property to your exchange. As long as the aggregate value of qualifying replacement property meets or exceeds the $1 million sale price of the relinquished property, you should not have any boot.
If there were a residence on the property and you planned to rent this residence to a farming tenant rather than making it your primary residence, this portion of the property would also be used for business, allowing the entire farm property to qualify as replacement property under Section 1031.
When exchanging FROM or BETWEEN farmland properties, you cannot defer taxes on the gain from the residence portion of the sale. This portion of the property value would be subject to taxation as it would not qualify under Section 1031. It might qualify under Section 121, which has its own rules that should be understood before selling your primary residence.
Non-real property on farmland and Section 1031
Property included in a 1031 exchange needs to be “real property.” Prior to 2018, it was possible to include “non-real property,” such as livestock, machinery, or harvested crops, in a 1031 exchange, but since the passage of the Tax Cuts and Jobs Act of 2017, Section 1031 only applies to real property.
Just like a primary residence on the property, any portion of the sale price associated with non-real property would be subject to taxation or some other tax deferral mechanism. Therefore, if your purchase or sale of farmland includes the equipment or livestock on that farmland, you will need to calculate its value to understand your tax consequences.
Mineral and gas rights on farmland under Section 1031
Many farms have land that is not intended for farming purposes, but rather is leased for mineral and gas exploration or designated as conservation easements. This land may qualify for tax deferral under Section 1031.
Mineral leases and royalties from oil and gas production are often considered real property interests under Section 1031. However, production payments for oil and gas production and the equipment used for exploration and extraction of the minerals may not be considered qualifying exchange property (it is critical to consult with a the right tax adviser to help you confirm what portions of the property will qualify for tax deferral treatment under Section 1031). Whether or not these portions of a particular property can be included in a 1031 exchange may depend on the specific agreement in place for those resources or in which state the property is located.
These types of complications aren’t easy to figure out, and highlight the importance of getting quality tax and legal advice – if you make your agreement with an oil producer without planning ahead for a future 1031 exchange, you may cost yourself down the road without realizing it.
Figuring out how much of your farmland can qualify under Section 1031
Because the sale of farmland can contain so many different components, some of which can qualify under Section 1031 and some of which cannot, deciding whether to engage in an exchange with farmland property requires careful consideration.
When considering farmland as a replacement property, you must deduct the value of a residence (if you plan to live there), any non-real property, and other non-like-kind property from the value of the farmland to determine the value of the exchangeable portion. If this value is lower than the value of your relinquished property, you may need to add additional replacement properties to achieve full tax deferral.
When considering selling farmland as part of an exchange, you need to understand that the portion of the property that is not eligible for Section 1031 may be taxable in the year the property sale is completed, and that this may lower the amount you have available to reinvest. And of course, if you’re exchanging from one farm to another, these calculations can become even more complicated.
Complex exchanges like these are nothing new to JTC. Our team has expertise in less-common scenarios like reverse exchanges or those involving Delaware Statutory Trusts. If you’re considering a 1031 exchange involving farmland, go with a Qualified Intermediary that has the experience and knowledge to help you navigate the particulars of your unique situation.
To learn more about JTC’s 1031 exchange services, click here.
