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The 4-1-1 on 1031s
Tax-deferred property exchanges could save you big dollars when you sell your property. But a few missteps can break the deal.
Whenever Kerrville, Texas, rancher David Gregory buys or sells land, he
makes certain his investment real estate contract contains one
important paragraph: wording that enables him to place proceeds into a
1031 tax-deferred exchange. Read more here
Landscapes - Summer 2008 Landscapes is a Tenth Farm Credit District publication
Tax-deferred property exchanges could save you big dollars when you sell your property. But a few missteps can break the deal.
Whenever Kerrville, Texas, rancher David Gregory buys or sells land, he makes certain his investment real estate contract contains one important paragraph: wording that enables him to place proceeds into a 1031 tax-deferred exchange.
The Capital Farm Credit customer and owner of Rod and Gun Resources Inc. is not alone. Rural property sellers in high-appreciation areas, and those who’ve built significant equity, are avoiding long-term capital gains taxes through the IRS Section 1031 exchanges. But, it takes the right planning.
“Just about every one of the contracts we see nowadays is written with a 1031 clause,” says Ronny Johnson, chief appraisal officer with Capital Farm Credit in New Braunfels, a hotbed of recreational property and housing development between San Antonio and Austin.
“With escalating prices, people have a lot of equity. We’ve seen quite
a few old ranching families that are in transition areas surrounding
metropolitan areas,” he says. “They are still trying to farm and ranch,
and as values escalate, they are moving out farther west.”
With a 1031 exchange, those families can sell their valuable property
for a significant profit and reinvest those proceeds in a like-kind
property, with no tax hit. “In these areas farther removed from metro
areas, the price per acre is less and they can buy more acreage,” he
says.
What Are 1031s?
Austin attorney and 1031-qualified intermediary (QI) Craig Dunagan of
Travis County Exchange Corporation has facilitated more than 1,500 of
the increasingly popular 1031 exchanges since the mid-1980s. That’s
when the new Tax Reform Act introduced “safe harbor” rules
necessitating the use of a third-party accommodator to escrow and
distribute the funds in deferred exchanges.
The IRS code allows sellers to apply net proceeds from investment
property sales to purchase “like-kind” investment property of equal or
greater value. Note, however, that the rules require (a) the seller to
reinvest cash received from the sale, and (b) if a mortgage was paid
off, the seller must either add cash equal to that mortgage amount or
replace the mortgage with one of the same or a higher amount.
Qualifying property includes farmland and ranchland, rental property
and other real property used for business or investment purposes.
Two types of situations that don’t work for 1031 exchanges, Dunagan says, are:
1. Personal Use Property – including personal homes and vacation homes used more than two weeks a year
2. Dealers – those in the business of buying and reselling
properties quickly or buying property in bulk and then carving it up
into multiple lots for resale
Types of Exchanges
According to Bill Hopewell, senior appraiser with the Federal Land Bank
Association of North Alabama in Albertville, there are three types of
1031 exchanges:
1. Deferred or Delayed Exchanges. With these exchanges, a
property-owner sells the property, with the proceeds going directly to
a qualified intermediary at the sale’s closing. The seller has 45 days
to identify in writing typically up to three potential like-kind
replacement properties, and within 180 days must close the purchase
transaction on the replacement property. Other rules allow more than
three replacement property picks.
2. Simultaneous Exchanges, in which the seller relinquishes title to
the old property and takes possession of the new property in the same
transaction.
3. Reverse Exchanges, whereby the replacement property is purchased
first and “parked” with an exchange accommodation titleholder, and the
relinquished property is sold within 180 days. The replacement property
is reconveyed by the exchange accommodation titleholder to complete the
exchange.
The most common type is a deferred exchange. However, this type can be
fraught with challenges. “You’re only allowed 45 days to nominate the
three properties, so you need to know where you anticipate buying and
try to identify your replacement property in advance,” says Larry D.
Kokel, a real estate appraiser and broker with Kokel-Oberrender-Wood
Appraisal, Ltd., in Georgetown, Texas.
That looming deadline can sometimes cause buyers to make rash
decisions. “As a lender, we sometimes see an individual highly
motivated to find something within the 45 days, and they sometimes end
up paying a premium,” notes Capital Farm Credit’s Johnson.
Making It Happen
Gregory agrees. Even though he has included the 1031 clause in many
contracts, it wasn’t until recently that he was able to use it. “We
were selling a ranch near Junction, and had already identified a ranch
near Kerrville to buy,” he says. “On this one, everything just fit into
place.”
The first QI his attorney recommended wanted a $2,500 fee to facilitate
the transaction, but Gregory opted for a California firm that his title
company recommended, paying them about $800. “It’s a little bit of a
gamble because your cash profit goes directly to them at the sales
closing, and you need to be sure you can trust them,” he says.
What Is “Like-Kind” Property?
Kokel says the definition of like-kind property is fairly broad, as
long as the properties are held for investment. “Around the perimeter
of Austin, prices are to the point where a Blackland farm is worth more
for houses than for cotton or corn,” he says. “I’ve seen a farm sold
and a 1031 done on an apartment complex. I’ve sold some property along
IH-35 that had appreciated substantially, and bought three other farms
in outlying areas that hadn’t had as much appreciation. Both scenarios
qualify.”
Although the Land Bank’s Hopewell says 1031s aren’t as common in his
area, he used one when selling some Clay County timberland whose value
had quadrupled. “We held it for investment and knew we would have
significant long-term capital gains, so we used a 1031 exchange to buy
a condominium in Auburn that we rent out to a student,” he said.
On farm and ranch investment properties that include a homestead,
Dunagan says federal and state laws allow the seller who has owned and
lived in a farm or ranch residence in two out of the last five years to
identify the house, an access easement and one acre as homestead. “The
beauty of that is you can take up to a half-million-dollar gain if
married and a quarter-million if single tax-free out of the residential
sale proceeds, and don’t have to reinvest it,” he says. “The rest
becomes the sale of the working ranch or productive farm.”
Get Good Advice
“If you intend to buy and sell investment property, it just makes sense
to put the 1031 clause in your documents,” says Gregory. “Every good
ranch Realtor knows about these, and the phrasing that must be included
in your contract.”
Before embarking on a 1031 exchange, the experts advise that you visit
with your accountant to understand your basic costs and potential
taxes, and then work with an experienced and reputable QI and attorney.
“Don’t just get caught up in the frenzy of doing it to save the 15
percent tax,” advises Kokel. “Make sure you are meeting your wants and
needs, and that your decision makes market sense.”
Considering a 1031? - Wording to Include in Your Contracts
SALE OF RELINQUISHED PROPERTY
“Buyer is aware that Seller intends to perform an IRC §1031
tax-deferred exchange. Seller requests Buyer’s cooperation in such an
exchange and agrees to hold Buyer harmless from any and all claims,
liabilities, costs or delays in time resulting from such an exchange.
Buyer agrees to an assignment of this contract to <insert QI
name> by the Seller.”
PURCHASE OF REPLACEMENT PROPERTY
“Seller is aware that Buyer intends to perform an IRC §1031
tax-deferred exchange. Buyer requests Seller’s cooperation in such an
exchange, and agrees to hold Seller harmless from any and all claims,
liabilities, costs or delays in time resulting from such an exchange.
Seller agrees to an assignment of this contract to <insert QI
name> by the Buyer.”
Article by Sue Durio
Photo by Janet Hunter
"Reprinted from Landscapes Magazine, Summer 2008, courtesy of the Federal Land Bank Association of South Alabama."
Bel-Ru Landing is a unique development with pristine pine trees and ancient oaks draped with Spanish moss. These sentinel trees stand guard over the banks of the historic Alabama River and its tributaries where steamboats of old plied these mighty waters.
By CHRISTOPHER PERCY COLLIER
Published: May 16, 2008
THE Robert F. Henry Dam near Montgomery, Ala., is a sprawling wall of reinforced concrete with 11 spillway gates that holds back approximately 234,200 acre feet of water, creating the lake called Jones Bluff Reservoir. Its lock, a massive concrete-lined chamber 655 feet by 84 feet, was built to raise and lower bulky barges hauling tons of wood and grain some 200 miles downriver to Mobile Bay.
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