Using a 1031 Exchange to defer tax on the sale of appreciated land
March 17, 2017
Many farm and ranch owners today are sitting on land that has dramatically risen in value. Depending on the amount of gain in their property and how it is owned, the taxes due on the sale of their appreciated land can amount to 20 to 50 percent or more of the value of the property.
By successfully completing a 1031 exchange, a landowner may realize several benefits. Some of these include:
1. Tax savings
In a properly executed 1031 exchange, capital gain taxes are deferred and transferred to the "replacement property" you purchase. Something many people are not aware of is that it may be possible to eliminate capital gain taxes altogether on the appreciated real estate by holding the 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. There is no limit on the number of times you can perform a 1031 exchange. For this reason, many people advocate that you "swap until you drop."
2. Improvement in cash flow return
A typical farm or ranch has a very low cash flow return based on the equity of the property. By selling and exchanging land into other types of commercial real estate, you may be able to greatly increase your annual cash flow rate of return. It's not uncommon for us to help ranch families triple their annual net cash flow.
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3. Elimination of active management of the investment
By hiring a professional property management company, you can rid yourselves of the day-to-day activities of managing real estate. This allows you to enjoy passive income or what some refer to as "mailbox money".
4. Wealth building
Deferring taxes on a sale of appreciated land with a 1031 exchange allows you to reinvest the full sales proceeds, undiluted by tax. The ability to invest money that would have gone to taxes in additional real estate may enable you to generate more income for retirement and pass more wealth to your children and grandchildren.
Consider the following example: A married couple sells land for $5 million with a cost basis of $1 million. Assuming a combined federal and state capital gain tax rate of 25 percent, they will pay approximately $1 million in taxes.
If this same couple were to do a 1031 exchange on the full $5 million sale, this $1 million that would have gone to pay taxes could be invested in additional real estate. Assuming the $1 million of real estate returned 7 percent per year, it would provide an additional $70,000 per year of income. Not only would this couple benefit from the additional income the real estate would generate while they are alive but they could pass significantly more wealth to their heirs.
To successfully complete a 1031 exchange, you must identify in writing the "replacement" property or properties you wish to exchange into within 45 days of closing on the sale of your "relinquished" property. You must close on your replacement property within 180 days of closing on the sale of your relinquished property.
If you are considering a Section 1031 Tax-Deferred Exchange, make sure to seek the advice of professionals with extensive experience in using this tool and be sure to start your search for replacement properties sooner rather than later. ❖
— Nolt is the author of the book; Financial Strategies for Selling a Farm or Ranch and the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families around the country who are selling a farm or ranch and transitioning into retirement.