Farmland Capital Gains & 1031 Exchanges

Recently, a client came to me with a question about farmland capital gains and their 1031 exchange. The lender they spoke with was concerned that they wouldn’t be able to transfer farmland capital gains into a NNN lease retail store with a 1031 exchange.  Specifically he was worried about the like-kind definition. So is there anything taxpayers need to be aware of in this type of situation? Great question.

Farmland Improved Property

Generally “unimproved” farm land may be exchange for other “improved” real property with buildings. 

Section 1.1031(a)-1(b) of the Income Tax Regulations defines like-kind as referring to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under  hat section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only or the grade or quality of the property and not to its kind or class. See https://www.irs.gov/pub/irs-wd/0404044.pdf

Most real property that is exchanged is 1250 property, with slow depreciation schedules.

Sometimes farmers have some 1245 property (that has faster deprecation) mixed in with the Relinquished Property that is sold such as cribs, grain storage bins, and silos.  If a high amount of the purchase price is allocated to the 1245 property, then that could trigger some gain unless this 1245 property can be matched-up with a sufficient amount of new 1245 in the Replacement Property in order to defer 100% of the gain.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges of farm property, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchanges with Disregarded Entities

Consider the following 1031 exchange example we recently ran into with a client: The client and his wife were looking to sell a 4-plex held by an LLC that they both owned together (100%). They wanted to use those funds in a 1031 exchange to purchase another apartment, but with a different LLC name that they would also both own 100%. Would this be allowed under 1031 exchange rules since more than one person owns the entity?

Disregarded Entities

The same taxpayer that owned the old Relinquished Property must receive the Replacement Property to complete the 1031 exchange. The question brings up the issue of disregarded entities.

The IRS will only allow an LLC that is a disregarded entity (owned solely by a husband AND wife in a community property state, e.g., California) to be titled on the replacement property. Rev. Proc. 2002-69. In this case a multi-member LLC owned by you and your wife sold the Relinquished Property. It is not a disregarded entity.

The old LLC owned the Relinquished Property, and the old LLC should be the owner of the new Replacement Property.  You can do this by changing the name of the old LLC by filing a name-change amendment with the Secretary of State; or by having the old LLC be the sole owner of the new LLC (which would also have to be a disregarded entity).

Please check out this article on 1031 exchanges, LLCs, and married couples for more information.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges and disregarded entities, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

A Complex 1031 Exchange Scenario

Working as a qualified intermediary for so many years, I've heard many complex scenarios and examples from clients. Here's one such scenario from a recent client.

The Scenario

The client had a building they were selling for $400k. Their existing first mortgage balance was $200k. They had a working line of credit with a balance of roughly $100k on it that was titled under a different LLC. However, the line of credit was tied (cross collateralized) to about four different properties (including the for sale property in question).

Here's the question: "Can this taxpayer pay off the 1st mortgage and this LLC and then use the rest of the funds to buy a new  replacement property?

The Short Answer

Ultimately, this is not a good plan of action for a 1031 exchange.

The idea behind IRC Section 1031 is to move ALL of your equity into a new like-kind Replacement Property so that there is a continuation of investment. To the extent that you divert your equity, you may end up triggering some gains.

In this situation, you should always talk to your CPA or accountant about getting the bank to release the 2nd loan with little or no pay-off, and then later pull some equity out of the Replacement Property in a subsequent transaction (after the 1031 is complete) by again cross collateralizing the property.

For more on this, read our previous article on Post-Exchange Refinancing. 

3 General Rules

There are three general rules of thumb to quickly see if you will defer all of the recognition of gain:

1. Typically you will acquire replacement property that is “up or equal” in Value (price);

2. You will roll over all of your Equity (net proceeds) from the relinquished property into your replacement property.

3. And to the extent that you were relieved of liabilities and debt, such as mortgages on your old relinquished property, the debt relief is offset by (1) new liabilities or mortgages taken on in conjunction with your purchase of the replacement property; OR (2) by investing additional cash in the replacement property equal to the amount of liabilities and debts that were discharged.

• Start Your Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

Special Documents You Need for a 1031 Exchange

What special documents do you need to do a 1031 deferred exchange? Under the treasury regulations you have to have an agreement with a facilitator - typically that's a qualified intermediary under the Safe Harbor regulations.  This agreement must limit your rights to receive the cash from the relinquished property closing. 

Sale Agreement

Next you need a sale agreement with the buyer, typically a third-party stranger that you're selling the relinquish property to. In that contract it's a good idea to put a cooperation clause that says you’re doing a 1031 exchange that’s part of an interdependent plan to do an exchange. Also in that clause you may want to provide that the buyer is going to cooperate with your 1031 by signing an acknowledgement that they received notice that you have assigned your rights in the purchase agreement to the intermediary.

On the Replacement Property Side

So you’ve got an exchange agreement, a sales agreement with the buyer, and a notice of assignment that the buyer’s going to sign. Then on the replacement property side the documents that you're going to need are an identification written document in which you designate what replacement properties you want to receive within the deadlines.

Then you typically get a purchase agreement or contract on some or all of those identify properties, again containing a cooperation clause. So you have a sale agreement with the seller of the replacement property. Then on top of that we have 1031 documents for the closing of the replacement property which would include a notice of assignment of the contract for the third party seller.

• Start Your Exchange: If you have questions about the documents needed for a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

Home Foreclosures and 1031 Exchanges

If you're about to be foreclosed on a property and you’re going to lose it involuntarily, one opportunity that you may not have even thought of is to do a 1031 exchange (or debt exchange).

Gain on the Sale

Your gain on the sale is computed by the difference between your adjusted basis in the property and the amount of debt relief that you're going to experience when you give back that property to the lender; NOT the amount of cash that you may or may not receive.

So if your basis is far below the debt, you may have MOB “mortgage over basis,” and that will result in taxable gain to you if you just give back the property to the lender. So even though you don't have any net sales proceeds of cash coming to you, you may still want to structure it as a 1031 exchange so you can defer the gain on the difference between your basis and a debt relief.

How do you do that? You get your qualified intermediary to prepare all the documents that would normally be executed in a 1031 exchange. You give notice to the lender (the buyer), and then you go forward and acquire a new replacement property within the deadlines.  

• Start Your 1031 Exchange: If you have questions about 1031 exchanges and foreclosures, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved