1031 exchanges are an increasingly popular option in areas where producers have an incentive to sell land. Here’s what you need to know and how to make them work for your business.
A 1031 like-kind exchange lets you exchange one piece of commercial property for another while deferring capital gains. Many ag producers use a 1031 exchange to sell one piece of land and buy another and avoid paying capital gains on the transaction.
It’s an increasingly popular option in areas where producers have an incentive to sell land to data center or solar energy companies and want to reinvest their earnings in their ag operation.
Here’s what you need to know about 1031 exchanges and how to make them work for your business.
What is a 1031 exchange?
Under Section 1031 of the IRS Code, the owner of a piece of property may sell it and buy another of a replacement piece of property of equal or greater value while deferring capital gains tax and depreciation recapture.
To qualify, both pieces of property must be held for business use, productive use in a trade, or as an investment. The new property you purchase must be of ‘like-kind’ to the one you sell. Fortunately, this definition is broad: farmland is like-kind not only to other farmland, but also to apartment buildings, undeveloped land, or other commercial property.
A 1031 exchange isn’t a direct swap of property. Rather, it’s a sale and a purchase bundled together in one transaction, made within a specific timeframe and documented for tax purposes.
What are the benefits of a 1031 exchange?
Making a 1031 exchange may allow you to:
Upgrade to higher-grade land by selling unproductive land
Consolidate acreage, improving operational efficiency
Exchange environmentally-sensitive land for productive crop or ranch land
The most important benefit is that capital gains and depreciation reduction are deferred until you exchange property in a non-1031 transaction.
You can sell and buy property in a 1031 exchange, then sell the new property in another 1031 exchange, and capital gains will continue to be deferred. In theory, so long as all your exchanges qualify under Section 1031, you can defer capital gains indefinitely.
What types of property qualify for a 1031 exchange?
All Section 1250 property qualifies for a 1031 exchange. This includes all depreciable real property used in a trade, in a business activity, or for rental purposes.
Personal property is excluded, meaning you can’t swap personal real estate in a 1031 exchange.
However, Section 1245 property—such as livestock or farm equipment—does not qualify. It did in the past, but with the Tax Cuts and Jobs Act of 2018, it became ineligible for Section 1031. (This is important if you’re researching 1031 exchanges and using resources published before 2018, when the change came into effect.)
It’s common in a 1031 exchange for both 1250 and 1245 property to be included. But only the 1250 property—typically land and permanent buildings—is subject to capital gains deferral. Any 1245 property triggers immediate capital gains liability.
For instance, as part of a 1031 exchange, you may sell a piece of cropland (1250 property) and include a pivot irrigation system (1245 property) in the sale. Provided you meet all other necessary conditions, capital gains on the cropland would be deferred, while you would become liable for capital gains on the pivot irrigation system.
Non-real (non-1250) property sold in a 1031 exchange, and any other non-exempt assets that change hands (including cash), is called ‘boot.’ Because of the complexity of separating real property from boot, and applying different tax treatments to each, it’s typical for ag producers to enlist the help of an accountant and/or a lawyer to structure a 1031 exchange.
What is like-kind property in a 1031 exchange?
In most cases, two pieces of 1250 property qualify as like-kind and may be included in a 1031 exchange.
Meaning, you could exchange cropland for cropland, or cropland for pasture, or pasture for feedlot real estate.
But you could also exchange crop land for a rental house, or pasture for an apartment building, or feedlot real estate for a commercial warehouse.
How are taxes deferred in a 1031 exchange?
In a 1031 exchange, two types of gains are deferred:
Long-term capital gain, taxed at the preferential rate of 0%, 15%, or 20% depending on your income level
Depreciation recapture—any depreciation you have claimed on the property you sell—taxed at your regular income tax rate up to a maximum of 25%
Your basis in the new property consists of its fair market value minus deferred gain. By reducing your basis in the new property, a 1031 exchange ‘embeds’ the capital gain you are deferring.
Depreciation recapture is similarly embedded by reducing your basis in the new property.
If you continue making 1031 exchanges, your basis in each new property will continue being reduced—in this way, it could be said that capital gains accumulate and ‘follow you’ from one new property to the next.
On the bright side, any property acquired in a 1031 exchange that you hold at the time of your death ‘steps up’ when it is transferred to your heirs. This step-up in basis means your heirs’ basis in the property is set at fair market value. In effect, the deferred capital gains disappear.
What are the deadlines for a 1031 exchange?
A 1031 exchange has strict timing requirements. You must sell property, identify new property for purchase, and then make the purchase within specific time limits. These limits are non-extensible except in the case of a presidentially-declared natural disaster.
Here are the deadlines you need to follow:
The 45-day identification period
You have 45 days after the transfer of the property you are selling to identify properties you could purchase as part of the exchange. They must be identified in writing—an ‘Identification Notice’—and submitted to your Qualified Intermediary (covered below).
You can identify up to three properties, each with a fair market value of 200% or more than the property you have sold. You can identify an unlimited number of properties valued at 200% or less.
The 180-day exchange period
You have until 180 days after you submit your Identification Notice, or until your taxes are due—whichever date comes earlier—to complete the purchase of a new property as part of the exchange.
The property you purchase must be substantially the same—with the same address and legal description—as one of the properties listed in your Identification Notice.
The two year rule
If you exchange properties with a related party—typically a family member or another ag producer you do business with—then they must hold the property for at least two years to avoid IRS scrutiny. The exchange must be made at arm’s length—that is, with the help of a Qualified Intermediary.
The IRS is on the lookout for individuals trying to dodge taxes by making 1031 exchanges with related parties. If the related party you’ve sold property to sells it before the two year period has passed, the IRS may scrutinize the transaction and declare the 1031 exchange invalid.
Who can serve as a Qualified Intermediary (QI) in a 1031 exchange?
A Qualified Intermediary (QI) manages the sale and purchase of property as part of a 1031 exchange.
They hold funds—money earned from the purchase of the sale property and used for the purchase of new property—in a segregated account during the period of the exchange. They also prepare and execute documents necessary for the 1031 qualification, such as the Exchange Agreement and the Assignment of Contract.
There is no special certification necessary for someone to act as QI. But a party in the exchange—the buyer or seller—can’t serve as the QI. And the QI may not have had a business relationship with the landowner within the past two years. This applies to accountants, attorneys, and other financial or legal professionals.
Even if there is no certification required, you should choose a QI who is experienced in 1031 exchanges. To reduce the risk of fraud, they should use Qualified Escrow Agreements to hold funds and carry out their transfer. And a certification from Federation of Exchange Accommodators (FEA)—like the Certified Exchange Specialist (CES) designation—is definitely a plus.
If you hire an accountant or attorney to structure a 1031 exchange, they may be able to recommend a QI.
Form 8824 and 1031 exchanges
Form 8824 is filed with the IRS to report a 1031 exchange. It is absolutely essential, and you must file it with your tax return for the year in which you make the exchange.
This is a complex, detailed form, and a small error could lead to your exchange being disqualified. Unless you moonlight as an accountant and already understand the ins and outs of Form 8824, it’s best to hire professional help.
Form 8824 includes:
A description of property given up or sold (relinquished property)
A description of property received (replacement property)
The purchase price of property received
The adjusted basis of property given up or lost
The adjusted basis of property received
The amount of cash or other non-real assets exchanged (the boot)
The amount of cash paid
Net mortgage relief (debt reduction)
Total recognized gain in the exchange
Total basis the replacement property
An identification of the replacement property (incl. date of identification)
The date of transfer of the relinquished property
The date of acquisition of replacement property
Information about related parties (if applicable)
Any gain or loss from the exchange
Summary of multiple exchanges (if more than one occurred in the year)
Your signature and the date
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This resource is provided for general informational purposes only. It does not constitute professional tax, legal, or accounting advice. The information may not apply to your specific situation. Please consult with a qualified tax professional regarding your individual circumstances before making any tax-related decisions.
