For investors looking to buy or sell agricultural property, mastering the details of the 1031 exchange is essential for optimizing investment opportunities. At Beaverhead Ranch Group, we have assisted dozens of Buyers and Sellers through this process. Agricultural real estate, which includes farms, ranches, vineyards, and orchards, consists of various assets such as equipment, livestock, water rights, crops, inventory, and the land itself. These properties also differ significantly in soil quality, climate suitability, water rights, and zoning regulations, posing unique challenges when identifying suitable replacement properties. Moreover, the timing of activities like planting and harvesting can affect the exchange process, necessitating meticulous planning to ensure a smooth transition without interrupting operations.
Determining Exchangeable Portions of the Sale
A crucial first step for sellers considering a 1031 exchange of agricultural property is to inventory the property’s various assets and identify which ones are exchangeable under section §1031. Intangibles like goodwill and inventory (including harvested crops) are not exchangeable under §1031. The Tax Cuts and Jobs Act of 2017 also removed the ability to exchange personal property assets, such as equipment and livestock. However, the Act introduced a provision for immediate expensing of certain newly acquired business assets, which sellers should discuss with their tax advisors to determine potential benefits.
The largest asset in most agricultural property sales is the real estate itself. Real estate used in business or held for investment can be exchanged for like-kind real estate under §1031. Crops and timber growing on the land are considered part of the real estate.
Exchanging Real Property Assets
Real Estate and Buildings: Agricultural property assets include land and any improvements such as houses, barns, or processing facilities. If a residence on the property is occupied by a tenant, worker, or caretaker, it is considered investment property and exchangeable under §1031. However, if the owner resides in the house, it is deemed the owner’s personal residence and not exchangeable.
For properties used both as a personal residence and investment, like a working ranch with a house, owners should determine the percentage used for investment versus personal use. Some gains from the sale of the personal residence may be excluded from taxation under IRC §121, while the capital gains on the investment portion can be deferred using a §1031 exchange. Revenue Procedure 2005-14 outlines how Sections 121 and 1031 can be concurrently applied to the same property.
Crops: Harvested crops are considered inventory and are not exchangeable under §1031. However, unharvested crops sold with the land to the same buyer can be exchanged, provided they are considered real estate under state law.
Water and Mineral Rights: Agricultural properties often include water or mineral rights. Perpetual water rights are like-kind to a fee interest in real estate, provided they are not limited in amount or duration. Shares in a mutual ditch, reservoir, or irrigation company may also be exchangeable if certain conditions are met, such as the company being a 501(c)(12)(A) organization and the shares recognized as real property interests. Certain mineral rights may also be exchangeable if considered real estate for tax purposes.
Like-Kind Requirement
Under §1031, capital gain tax deferral is possible when exchanging property held for business or investment solely for like-kind property. Contrary to common belief, like-kind does not mean exchanging a farm for another farm. It encompasses any real estate interest, including bare land, commercial property, industrial buildings, retail stores, apartments, duplexes, long-term leasehold interests, and some water and mineral interests. Thus, agricultural property owners can exchange into various types of real estate.
Identification Process
Replacement property identification must be in writing and sent to the exchange company, the seller, or another party involved in the exchange who is not disqualified, like a real estate agent or attorney. This identification must occur by midnight of the 45th day following the sale. The IRS limits the number of properties identified to three (the “three-property rule”) or, if more, their total fair market value cannot exceed twice that of the sold property (the “200% rule”). If these limits cannot be met, the “95% rule” allows for identifying as many properties as needed, provided 95% of their value is purchased. Identification must include a complete address or legal description and indicate the tenancy in common interest share if less than a 100% interest is acquired.
Timing the Exchange with Agricultural Cycles
Timing is critical for 1031 exchanges in agriculture, given the strict deadlines for identifying and acquiring replacement properties. These deadlines, set at 45 and 180 days post-sale respectively, must align with planting and harvesting seasons to avoid disrupting operations. For example, a farmer selling a vineyard in the summer must identify replacement properties by late summer or early fall and finalize the purchase, considering harvest activities. Additionally, proceeds cannot be used to purchase severed crops, classified as personal property. Effective timing and planning are essential to synchronize the exchange process with agricultural cycles.
Conclusion
Selling a farm or ranch involves more than just real property. Beaverhead Ranch Group has brokered dozens of transactions involving 1031 Exchanges. Understanding tax strategies like the 1031 exchange can help investors maximize tax savings and funds available for reinvestment. Engaging a qualified intermediary and advisors knowledgeable in 1031 exchange rules and agricultural real estate can provide crucial guidance for leveraging this powerful tax tool in agricultural land investments.
