1031 Trade Out
By James D. Ritchie

A boon to farmers on the urban edge is driving prices in rural farmland markets.

Penney’s and Target stores and Starbucks coffee shops now are sprouting on land that 2 years ago was the Merz family farm in St. Charles County, Mo.

“We sold 96 acres to commercial developers and a builder of condominiums,” said Robert Merz. “Earlier, the Missouri Department of Transportation took 23 acres out of the middle of the place.”

Merz isn’t revealing a figure for the entire sale of the property, but it was enough money to put the family in a tight tax bind—unless they came up with a way to defer capital gains tax on the transaction. They began looking into lessening the tax load once they sold the property—particularly with a tax-deferred exchange under Section 1031 of the Internal Revenue Service code.

“Actually, we had negotiated with the developers for some time before the sale,” said Merz. “But we were operating as a family corporation, and the replacement land had to be titled the same way, which complicated things and would make the tax bite deeper than it would be with an individual seller.”

An individual faces a maximum 15 percent federal tax on the capital gains, plus whatever state capital-gains taxes are in force when the property is sold. By employing a Section 1031 exchange, the seller postpones those taxes until the new property is re-sold or otherwise distributed.

“As a corporation, we were subject to a higher capital-gains tax rate,” explained Merz. “The combined federal and state tax would have come to 38 percent—more than a dollar out of each 3 dollars of gain in the St. Charles County property.”

Section 1031 exchanges offer some real protection against an immediate tax bite. Let’s say an investor has a $500,000 capital gain on the sale of property and incurs a liability of $125,000 in total taxes (from combined depreciation recapture, plus federal and state capital gains). If the investor gets a cash-on-cash return of 7 percent, with a 1031 exchange the $500,000 yields $8,750 more per year than investing the after-tax $375,000 at the same rate.

The IRS classifies real estate in four categories:
1) Residences and other property held for personal use; 2) Property held for re-sale or development; 3) Property held for productive use in a trade or business; 4) Property held for investment.

The last two kinds qualify for Section 1031 tax deferral; the first two do not, said Parman Green, University of Missouri farm management specialist. Also, “paper” assets such as stocks, bonds and lease agreements do not qualify. Both the property sold and the property bought to replace it must be of “like kind,” but it is your use of the property that determines its classification rather than its grade or quality.

“There’s a broad definition of what kind of land you can buy to replace the land sold in a 1031 tax-deferred exchange,” he added. “There aren’t many limits on the kind of property you can replace original property with. You can swap fully-developed farm land for bare, unimproved land and vice versa.”

“We could have replaced our St. Charles County land with about any kind of income-producing property—a boat marina, a convenience store, whatever,” said Robert Merz, who with his brother, Richard, represented remaining family members in finding exchange property. “But farming is what we know, so we went looking for replacement farm land with the potential to earn at least a 5 percent return on our investment.”

And they didn’t have much time to look. The rules say that replacement property must be found and identified within 45 days of closing on the tax-deferred sale.

“Then you have another 135 days [180 days total from closing] to close the purchase on the replacement land,” said Merz. “That isn’t much time. We were scrambling to get everything done by the deadlines.”

Robert and Richard Merz centered their search for replacement land in northern Missouri, primarily in Linn and Livingston counties. They looked for productive bottomland that would likely meet their goal of returning 5 percent on the investment. The largest tract they purchased was 925 acres, plus several smaller acreages. They wound up with several hundred acres. Most of it was the kind of land that fit their objective.

“Because of the tight time line, we probably paid more for some land than we might have if we’d had more time to negotiate, and we bought some land that was less than ideal for our purposes,” said Merz. “We paid more than $3,000 per acre for one place that had irrigation. I’m sure this whole thing is part of what is driving up land prices.”

Parman Green agrees. “It’s affecting land prices everywhere,” he said. “People are selling land close in to metropolitan areas for big sums and then looking for replacement land out-state. Tax-deferred exchanges have the effect of boosting land prices generally.”

The IRS imposes one of three different identification rules on Section 1031 exchange property:
The three-property rule—the taxpayer can identify up to three properties, of any value.

The 200-percent rule—the exchanger may identify more than three properties, but the total fair market value cannot exceed 200 percent of the fair market value of the property sold.

The 95-percent rule—if the exchanger identifies properties with a value in excess of both the three-property and 200-percent rules, then he must acquire at least 95 percent of the equity of all properties identified.

“We went with the 200-percent rule, because we sold unencumbered land and intended to buy replacement land for cash,” said Merz. “The 200-percent rule fit our situation better.

“This was an interesting exercise; it kept my mind limbered up for awhile,” he added. “But as long as you follow the rules—and there are many—it’s not that difficult.”

One of the first things a seller of 1031 exchange property needs to do is line up a “qualified intermediary.” An intermediary can be virtually anyone without a direct interest in the transaction, except for the taxpayer himself or a real estate broker or agent. The qualified intermediary makes sure that 1031 rules are understood and followed, and prepares the paperwork in accordance with 1031 procedures. Ideally, the intermediary should be bonded and familiar with 1031 exchanges.

“The intermediary takes possession of the money after the initial sale closes, too,” said Merz. “Under the rules, the seller cannot handle the money beforehand. If you spend any part of it, you pay taxes on all of it.”

“And you need to remember that a 1031 exchange doesn’t get rid of the taxes due,” said Gary Hoff, University of Illinois taxation specialist. “The initial tax basis applies whenever you sell the asset or give it away. With a Section 1031 deferral, you’re simply postponing the tax.

“In some situations, and with the current low capital-gains tax rates, a taxpayer might decide to go ahead and pay the tax on the sale of the initial property,” Hoff added. “There’s no guarantee that capital-gains rates will not go up again, and if the individual plans to transfer the property (say to heirs) before long, having the tax out of the way might be a good thing.”

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