IRC Section 1031 Exchange: A powerful financial tool for cattle producers

Some of the benefits of a 1031 exchange are:

1. Tax deferral (immediate and indefinite)

When selling land, a 1031 exchange allows a person to defer capital gain taxes. The taxes are transferred to the property a person exchanges into, which is called their replacement property. Tax is not due until the person sells the replacement property without utilizing a 1031 exchange. Since there is no limit to the number of exchanges a taxpayer can complete, it is possible to defer the payment of tax indefinitely.

The 1031 exchange is commonly referred to as a tax “deferred” exchange, implying that taxes are not eliminated, only deferred until the replacement property is later sold in a taxable transaction. However, it is possible to potentially eliminate capital gain taxes altogether on the sale of property by exchanging into and holding property until death.

Under current tax law, heirs of a descendant’s property receive a “step-up” in basis of the property’s tax basis to its fair market value upon death. This step-up in basis could conceivably enable the heirs to inherit property and then sell the property for fair market value soon after the decedent’s death and pay little or no tax. Thus, if you swap until you drop, it may be possible to not only defer taxes on the sale of property but permanently eliminate them.

2. Improvement in cash flow return

The annual cash flow return on ranchland is typically very low. By exchanging land into other types of real estate, such as an office building or apartment complex, a person may be able to increase their cash flow return.

3. Consolidation or diversification

Ranch owners who have accumulated multiple parcels of land may eventually decide to consolidate their properties into one larger property. Conversely, a large land holding could be exchanged into multiple properties. Exchanging into different types of properties and in different geographic locations can be an effective way to reduce investment risk.

4. Elimination of active management of the investment

Exchanging properties you manage yourself into other passive real estate investments or into properties that are professionally managed may enable a person to free themselves of the day-to-day activities of property management.

5. Wealth building

The greatest potential benefit from using a 1031 exchange may be the ability to preserve all of the equity in the relinquished property and reinvest the full sales proceeds, undiluted by tax.

Consider the following example: A couple sells land for $2.5 million with a cost basis of $500,000. Assuming a combined federal and state capital gains tax rate of 24% plus the 3.8% Net Investment Income Tax, they will pay approximately $556,000 in taxes. If this same couple were to do a 1031 exchange on the full $2.5 million sale, this $556,000 tax cost could be invested in additional real estate. Assuming the real estate grew at an average annual compound rate of 9% (income plus appreciation), in 20 years this $556,000 that would have gone to taxes would be worth approximately $3.1 million.

Not only would this couple benefit from the additional income the real estate would generate while they are alive, if they hold the property until they die, and if real estate continues to receive a step-up in basis upon death, they could potentially pass close to $3 million more to their heirs.

How it works

An exchange agreement between the taxpayer and a Qualified Intermediary (QI) must be set up prior to any sales transaction. A QI is a person acting to facilitate an exchange under section 1031 and the regulations. This agreement establishes the exchanger’s intent to complete a 1031 exchange and details each party’s roles and responsibilities.

The first part of the exchange occurs when the taxpayer assigns their rights to sell the relinquished property to the QI. Upon the sale of the relinquished property, the proceeds are held by the QI in an exchange account.

The next portion of the exchange involves the identification and purchase of replacement property. Replacement property must be identified in writing within 45 days of closing on the relinquished property and must be closed within 180 days of the closing on the relinquished property.

Once a replacement property is selected, the rights to acquire that property are assigned to the QI, and the funds held in the taxpayer’s exchange account are sent by the QI directly to the closing for the purchase of the replacement property.

There are complex rules and strict time parameters for completing a successful 1031 exchange. For more information, request our free wealth guide on 1031 exchanges by calling (800) 517-1031.

Chris Nolt is dedicated to working with families selling a ranch and transitioning into retirement. He is also the author of the book Financial Strategies for Selling a Farm or Ranch, which is available on Amazon.