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The IRS allows farmers to defer capital gains taxes on the sale of their farm property if they reinvest in “like-kind” property. The goal is to encourage agricultural investment and prevent double taxation on investments that have increased in value. However, many farmers don’t know about this tax break or what it means to them – so we’re going to dive into the top 10 red flags farmers should look out for when going through the process of acquiring one of these exchanges.
1. Trading Down In Value
If you want to defer all tax on an exchange, you need to be trading up in value when following Section 1031. If you use the benefit of exchange to trade down in value or purchase your new property for less than what you sold, the IRS will consider it a “partial sale” and will not allow any tax deferment on this transaction. This can be one of the largest pitfalls when using Section 1031. It’s best to work with a qualified intermediary who knows how to keep this from happening.
2. Failing To Stay Within The Time Limits
When we sell property, we generally have 45 days (or 180 days if we executed and did not elect) to identify and purchase like-kind replacement property that meets all requirements of Section 1031 exchange. Failure to do so on time can result in the IRS imposing back taxes so that there are no delays, penalties, and interest. If you are selling your farm, it’s in your best interest to immediately identify potential replacement property.
3. Failing to Identify Like-Kind Replacement Property in Time
Just like staying within the time limits of Section 1031 is crucial for tax deferment, identifying the correct replacement property in a timely manner is essential for ensuring that your exchange will be completed without any problems. It’s important to have qualified representation when locating potential replacements because low-hanging fruit may not always be available or meet strict IRS guidelines. For example, swapping out pasture land for pasture land wouldn’t cut it. You need acreage that meets specific requirements under Section 1031.
4. Not Documenting the Exchange
Any transactions that occur between the time you sell a property and acquire replacement property (all within 45 days or 180 days of the actual sale, depending on whether it was an election) must be documented by what’s referred to as “qualified intermediaries.” If all these transactions aren’t properly documented, the IRS will treat the entire exchange as one big taxable event. You’ll lose out on your chance to defer taxes through Section 1031 if this happens.
5) Not Understanding Timing Requirements
As mentioned above, timing is critical when using Section 1031. If you fail to meet the time requirements of this provision, there are some severe consequences that will arise. For example, if you buy replacement property too early (before selling your current property) or sell your existing property after buying replacement property but before the end of the exchange period – no matter what amount is involved – it’s considered a taxable event with immediate tax consequences for you. A good intermediary will make sure these things don’t happen.
6) Not Planning Ahead
Depending on the type of farm business you have, there likely are unique aspects of a farm operation that can complicate an exchange. Proper planning ahead of time is important for ensuring success with an exchange. A good intermediary will work with you to ensure that your exchange isn’t too complex – or that it can be completed in a timely manner.
7) Not Understanding the Actual Costs of an Exchange
This is especially important for farmers who are new to exchanges. There are real costs involved in using this provision, and while some may be negligible (like fixing up or renting replacement property), others can add up quickly (like marketing costs). A great intermediary should make sure you understand all of these costs before moving forward with an exchange transaction.
8) Flipper and Dealer Status
If you’re buying replacement property to resell it, your broker needs to be aware that the IRS will treat you as a “dealer,” – which can have very serious tax implications. The flip side is also true. If you’re selling your current farm and trying to defer taxes by purchasing new land to hold onto, then the intermediary looking after your exchange needs to understand that you won’t be taxed as a dealer (and penalties may ensue if this isn’t respected).
These eight key issues for farmers using a 1031 exchange are important to keep in mind. They can help avoid costly mistakes that could lead you down the wrong path and cost you your tax deferment opportunity. Let our team of experts provide guidance on how best to use Section 1031 exchanges for farming or ranching purposes by contacting us today! We’re ready and waiting to partner with you so that there’s no chance of jeopardizing your farm business – let alone any potential tax benefits it might have earned through this provision.