The 1031 exchange tax deferral tool
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Jodi:
Welcome to the Successful Farming Podcast. I'm Jodi Henke. This podcast is brought to you by Grasshopper. Do more on mow day with our Grasshopper mower, made for a smooth cut from the fields to your front lawn.
Jodi:
A large number of our nation's farmers are aging, which means an uptick in the transfer of land ownership. In this episode, learn about how the 1031 exchange, the estate tax and stepped up basis could affect your farm family now and in the future. Successful Farming's Markets Editor, Mike McGinnis gets an update on these critical issues with David Brown, Certified Exchange Specialist with Iowa Property Exchange.
Mike:
We're going to be talking to David about a topic that is probably a fairly heavy topic for folks in agriculture, but a very important one. It's about 1031 exchanges. Here in a second, David will give us the exact definition of 1031 exchanges. The layman's term or straight reference to the 1031 exchange is of course is when farm families are able to use this tool as a way to pass along the farm without encumbering themselves with a lot more taxes. We're also going to talk about the stepped up basis and estate taxes. And those three in a lot of ways are tied together, and in some ways they're not.
Mike:
We've asked David to talk about this because currently the Biden administration is considering some legislation on this. It's in the works, but nothing has passed yet, but the end result could be very impactful to a farm family. We're going to spend some time going through this. I would say if farm families are looking for some really good information to help the future of their farm financially, this information is key. It's probably some of the best information you'll get for a long, long time. It's information that some people just don't pay enough attention to, and I'm sure David would attest to that.
Mike:
David, first off, give us the exact definition and help folks understand what a 1031 exchange is.
David:
Absolutely. Section 1031 allows for the exchange of real properties, whether it be a farm, a commercial building, any investment property, commercial or business use properties, as long as somebody sells a property and goes into a new replacement property. What section 1031 does is it allows that tax payer to defer the tax and move that gain or retain their equity in order to go into that new asset. It was enacted in 1921 with the recognition by Congress that as long as taxpayers are keeping dollars invested in the economy, they want to incentivize investors and landowners to retain those dollars, keep them moving, and they don't want to penalize investors and business owners if they were to sell and reposition assets. So it's really an incredible economic driver and ability for business use and landowners to retain capital, continue to invest, continue to build their holdings through time. It's not a tax avoidance tool. It's a tax deferral tool.
David:
In essence, if I'm taking an example, if somebody were to sell an 80 acre farm that was 20 miles away and bringing it closer to home to a property that maybe came up for sale once in a generation, maybe it's the neighbor's property, they could sell that parcel and go into the new property without paying that capital gains tax and being penalized and being tax-locked for fear of paying that. It really allows business and investors and farmers and others to retain their capital within their operation.
Mike:
Is this an option that farmers and their families most of the time don't even consider or think about until the farmer's getting ready to sell, or there's some sort of passing of the owner, now they have to figure out what to do with the farm? I'm just trying to express that this 1031 exchange is not really something that you hear a lot about in the general discussion with agriculture topics, but it's a really important one. I'm just wondering if farm families shouldn't be considering this or thinking about this or talking about this at the dinner table or Thanksgiving table, whatever, more often.
David:
Yes and no. I think the farmers in ag is big business and it's sophisticated business. I think that as people have come to understand section 1031 exchanges more and more over time, that there is a general awareness. Really the level of sophistication, understanding of exchanges has gone up year by year. Even when we started the business in 2003, just the appreciation and understanding for the benefits and how powerful 1031 is to farmers and loan owners, has gone up significantly.
David:
Now with that said, if somebody has held onto a farm generationally or acquired assets and hasn't done a lot of selling and repurchasing, it certainly is something that could be new to them in terms of awareness. Oftentimes, an example is, we'll have the farmer family who will go connect with the accountant and say, "Gosh, I want to," again, in my example, "bring this 80 acres, that's 20 miles away and put it into a higher quality ground that adjoins that another parcel." The accountant would say, "Well, gosh, have you considered a 1031 exchange?" Or the tax attorney or just the rural practitioner would say, "Hey, here's an opportunity if you're going to do this. You should utilize section 1031 because it allows you to defer the tax as opposed to using the after tax dollars from the sale and having to reinvest it."
David:
It's probably a mix of awareness. There's surprisingly, I think a fair amount, and if there's not, to your previous point, this is one of the most powerful tools for farmers and landowners available and real property owners. It's just been a remarkable economic driver, and that's why it's been in the code for a hundred years.
Mike:
Well, this is a time in agriculture that we're seeing a lot of land transferring from retired farmers or unfortunately farmers that have passed away. The average age of the farmer is getting older and there could be a lot of land ownership transferred. This is an important topic for farm families, and that's why we're trying to discuss it today.
Mike:
David, I know you have some examples to help explain the whole idea of the 1031 exchange. I think examples are probably the best way to help people understand what kind of option this might be for their farm families.
David:
There's really an under appreciation for how section 1031 is utilized in ag. What I can tell you is our business is primarily, remarkably based on ag transactions. I always say, and I can't back this up, but if we don't do more ag exchange transactions as a percentage of our business compared to any other exchange company in the country, I'd be surprised. We handle thousands of these exchanges.
David:
By way of example, we took statistics from 2015 to 2019 and out of the $3 billion that our company handled, and that's just our company, that's not the whole universe of exchanges, approximately $2.3 billion of those involved ag assets. When you talk about the impact of tax provisions and legislation, and what's the day-to-day impact to the ag community, it's enormous what section 1031 does.
David:
Oftentimes you don't hear the examples of how 1031 is used. What I can say with certainty out of being in business for nearly 20 years and handling thousands of exchange transactions, is that 1031 is utilized by every day, average, small to medium farmers and landowners to improve their operations, reposition, and for really opportunities that are well intentioned and serve a highly beneficial utility for the economy and for farmers.
David:
Here's an example. 80 acres, 20 miles away. We already talked a little bit about that. The farmer's neighbor lists 160 acre high quality farm. So 1031 allows farmers to reposition to consolidate, to become more efficient by having that larger parcel. This would be the first example.
Mike:
So under that example, David, the farmer looking to do a 1031 exchange would have to sell some property and take that money and buy the neighbor's, which is better soil?
David:
Yeah, or to adjoin an existing, larger tract that allows them to have greater operational efficiencies. So yes.
Mike:
I'm just trying to get to the point that the exchange part is exchanging some poor soil ground for some better, but that has to be for tax purposes. You can't just pull some money out of the bank, buy that neighbor's ground and use that as a 1031 exchange, is that correct?
David:
Exactly right. If this 80 acre tract sold for $500,000 and the 160 acre tract sold for a million dollars, what happens is at the time of the closing, based upon setting up some exchange documents, and that's what our company does, is we handle the exchange document process, which is a requirement under the IRS rules. So we would set up exchange documents at the time of the closing. The funds go to a separate account that's set up for the exchanger. And then at the time of the closing of 160 acres, documents would go in place to make sure that everything is compliant with IRS rules, and the $500,000 combined with either new debt or new cash the farmer would put into the property, would be used to acquire the 160 acre parcel.
David:
Variations of this occur. It could be a two 40 acre tracts or an 80 and a 40. You can sell multiple properties and go into one larger property and vice versa.
Mike:
I'm just trying to make sure that people understand where the money is coming from to buy this 160 acres. Does it have to come from the sale of another farm?
David:
No, not from another farm. Yes, I mean another real property. Also, an important clarification too, 1031 doesn't require a farm for a farm. Any real property can be exchanged for any other real property. So a farmer could go into commercial asset, retail, office, storage, and the same can be true. You can take commercial assets into farm assets. One thing I want to really jump on is that is a very, very rare occurrence. I mean rare in the sense of a fraction of a percent that people go from non-farm assets into ag assets. Sometimes 1031 gets knocked for commercial or urban buyers going into farm assets, and that doesn't happen. We can demonstrate that through our statistics.
David:
Farmers understand farms, commercial owners understand commercial, so they generally stick to their lanes and that's how it works.
Mike:
It can be multiple tracts.
David:
Yeah. It could. Any variation of sizes or tracts. There's some limits in terms of how this can be accomplished under the rules, but for purposes of our discussion, people should assume they could sell multiple tracts to consolidate, or if they wanted to go into a more diverse approach and purchase different assets, maybe in different parts of the country because of climate issues or whatever, that's an option as well.
David:
1031 is also becoming more and more utilized as a conservation tool. What I mean by that is permanent conservation easements are considered real property assets for exchange purposes. So if the NRCS comes and says, "Hey, I want to buy these wetlands. This farm, we're going to put it back into wetlands. So what we're going to do is buy the easement from you for a per acre value, which equates to the loss of the ability to produce on the property. So if the property is worth $5,000 an acre, we'll pay you $4,000 an acre, take those sensitive acres out of production that it can go into a more environmentally appropriate property."
David:
So with the nutrient reduction strategies and whatever intent farmers concluded on accomplishing, it's being used as a tool to take tougher acres, wetter acres out of production and go into something else that might be more appropriate.
Mike:
The conservation point is very important. We're hearing more and more about the conservation efforts that the Biden administration is trying to promote, and farmers may be faced with more decisions regarding conservation going on.
David:
Yeah. When you think about the potential for the build back better infrastructure plan, climate, that's going to be a big part of it. There have been dollars allocated to NRCS to buy easements. There's wetlands reserve, there's grasslands reserve. There's emergency watershed dealing with, in our neck of the woods, Missouri and Mississippi watershed. That could be an opportunity to have federal dollars under any new infrastructure plan. Those could be utilized to acquire those sensitive acres, which would allow farmers to be able to exchange in something else, which not only serves the conservation purpose, but allows them to keep cash flow and keep in that same level of operating capacity they had before the sale.
Mike:
Give us some other examples if you would. When is a good time for farmers to consider this option? What other important things should we be mentioning here and expressing to farmers about the option of a 1031 exchange?
David:
You mentioned the generational transfer that's accelerating. 1031 is being utilized as a tool to sell to siblings, to sell to kids. What that does is allows the landowner or the farmer to go reinvest somewhere else. Oftentimes that's the case of son or daughter buying the home farm. They want to preserve where everything began, and it may be a good situation for them to work through the family, repositioning the situation.
David:
We have seen large numbers of properties owned by siblings that have been inherited. They are owned in a tenant in common or a fractional interest by, let's just say it's three siblings. They inherit the property, maybe they inherited it 15 years ago. Their basis is lower and they've had appreciation. One sibling wants to buy out the other two siblings and those siblings would like to go in to buy some other replacement properties. So in terms of the family planning and ability for the producing sibling to keep the home farm, it's a tool to facilitate those types of transactions. We see that all the time.
David:
Retirement planning; not only is 1031 used for operations, but if a retiring farmer wanted to go into some other asset or a rental property in Arizona for whatever reason or Florida or maybe to be near the kids in Milwaukee or somewhere else, there's opportunities to do some planning to allow for farmers and landowners to go into assets and other areas of the country that might serve them more appropriately. Maybe they want to get out of farming for whatever reason and going to some commercial assets for other reasons. Again, that's a pretty rare situation.
David:
In the past there was discussions about, "Hey, you should only be able to exchange a farm for a farm." And after lots of studies by USDA and others, the conclusion was, gosh, you're only hurting yourself because first of all, there are few people exchanging out of non-farm assets into farm assets. And the second, what if the farmer or the landowner wants to go into something else for whatever reason, that shouldn't be limited, especially when it's not really a factor, an impact on ag.
Mike:
What can't you use money to reinvest in? In other words, I sell a farm, what can't I use that money for in a 1031 exchange? You're saying that I can take that money and reinvest in rental property and possibly a vacation home, maybe go into some other type of business, commercial building, storage, whatever. What is it that you can't go into or use that money from the farm sale to invest in?
David:
You can't go into stocks. You can't exchange a real property asset into stock. That includes shares of the family corporation that may be part of the family ownership structure. You can't go into notes, bonds. You cannot go into personal property. You cannot exchange a farm for a combine. You cannot exchange farm for really any personal property asset. The house that you live in, no. Residential real estate qualifies, but not your personal residence. That's a whole different provision. So if somebody had a house that they had lived in for two out of the last five years, they could exclude gain of up to 250,000 for an individual and 500,000 per couple.
David:
Now there is some planning that if somebody said, "Gosh, I want to go into a house from Mason City to Des Moines," if that property were rented for a couple of years, after that two year period, it could be converted to a personal residence. They wouldn't be able to exchange out of it again, but there's some really remarkable opportunities to take an investment asset and after a couple year period of time, reposition it into a personal use asset that's allowed under the tax code.
Mike:
You also can't sell the farm and use that money to buy cryptocurrencies, correct?
David:
You definitely cannot. The Tax Cuts and Jobs Act eliminated artwork, cryptocurrencies, and a number of other different things.
Mike:
No Bitcoin.
David:
Right. Right.
Mike:
Let's move on to estate taxes. Give us the current state of estate taxes. When people hear other people talk about this, they think they're talking about state taxes, but this is estate. Give us a current state of what's going on with estate taxes.
David:
Okay. Estate taxes, there's three issues I think that are near and dear to farmers, that there's concerns about what is the potential impact of legislation. Estate tax is one of them. Under the present law, there's an exemption for estates of $11.7 million for an individual and $23.4 million per couple. So if the farm family owns assets of under 11.7, there is no estate tax. If for a couple again, mom and dad could pass on $23.4 million together and there will be no estate tax. Prior to the Tax Cuts and Jobs Act in 2016, that exemption was $5.5 million for an individual and $11 million per couple. So that got bumped up during the Tax Cuts and Jobs Act. That's referred to as the death tax. It gets lots of attention in the media. And it's important. For farm families that have these values of assets, congratulations.
David:
Mike, here's really, I think the practical impact, which is really important. I was researching a Des Moines Register article, talked about what was the impact of the estate tax in 2016 at the $5.5 million and $11 million exemption level. What the studies, or what the statistics show is that 0.1% of the states pay taxes nationally. Now what that means is to the ag context, and this is across the country in 2016, this isn't the $11 million limit, this is the $5.5 million pre-Tax Cuts and Jobs Act limits, so at that pre-Tax Cuts and Jobs Act limit only 682 filers nationally owned farm assets. And then dialing that down even further the article stated that nationally only 160 farm operations owed estate tax. And then in Iowa alone, and this is all assets included, not just farms, only 60 Iowans paid estate tax in 2016. That was the $5.5 million limit. That got doubled.
David:
So when considering what is the impact on agriculture of a proposed reduction in the estate tax exemption, which the Biden proposal is $3.5 million and $7 million per couple, so it definitely would have an impact. I'm not advocating for or against. I completely respect how it's important to ag. But I think the conclusion after I was looking at this is it just would have a really nominal impact for the most part. Right. I know it's important to the ag associations and that's great, but that's the reality.
Mike:
So the threshold levels for that estate, that death tax, were so high that it wasn't really including as many people as the Biden administration's levels might because you're saying that the threshold levels are being dropped and that could catch a lot more farm families out there.
David:
It could, but with the appreciation of land, we're in a whole different world than we were even five years ago. We're seeing what's happening with commodity prices. There definitely has to be an inflation factor that goes into it. Keep in mind, these are Biden campaign proposals. This is not legislation. I'm on the Governor Affairs Committee for a national trade organization. Our lobbyist in DC is well-tuned and I've consulted with him. I'm saying, “Hey in preparing for this, what's the practical impact of the Biden campaign proposals? What's likely the results."
David:
One, you've got this proposal from the campaign, you have the existing exemption of $11.7, if there's any change it's going to be probably somewhere in the middle, in which case it still probably impacts few farmers and landowners. This is a big deal to ag. So ag is going to have a say. There's potential carve-outs for farm exemptions, ongoing business owners. There could be a carve-out that says you don't owe it until heirs sell the property. So there's different things that can be utilized to mitigate the impact to the extent that this becomes an issue.
Mike:
So time-wise, what are your lobbyists telling you about this possible legislation?
David:
All right, so we just finished the rescue plan ... I don't know if it's finished, but it feels like we're not ready to get it signed. Presidents historically, and President Biden is at peak power for the first eight months of his administration. So all eyes will go to the build back better plan, which is going to relate to infrastructure, green energy. So all eyes will go to that. Thought is between now and August or September is when the pen will go to paper and we'll start seeing what comes out of that.
David:
There's all kinds of priorities and different diverging interests within the Democratic caucus, including centrists, who would say, "Gosh we're not messing with estate tax in Montana or a mansion in West Virginia, farm states." There are a number of centrists swing vote Democrats that will have a problem with tax provisions that would impact ag.
Mike:
The other thing we want to talk about that goes along with this topic a little bit, David, is stepped up basis. You have a family that the parents may have died, or the kids somehow have inherited the farm. If they're considering selling the farm, are they going to get taxed on this farm sale at the current rate or a value of the farm, or is it going to be at the greater value of when the farm was purchased in the 50s or 60s or 70s, whatever, years ago?
David:
Stepped up basis is really the cost of the asset for tax purposes. My mom and dad bought a property for $100,000 in 1985 and the value rose to $500,000 today, their basis, in other words, their initial investment is 100,000. If they sell that property today for $500,000, they do have to pay the tax on the $400,000 of gain. Stepped up basis says that if the heirs inherit the property today and that property is valued at $500,000, the basis for mom and dad goes from $100,000 to $500,000 in the hands of the person who inherited the property.
David:
Here's another example. If a property was purchased for $500,000 in 1980 160 acres, sale price of the property would be $1.5 million. There's a million dollars of gain that would be taxed if they sold it today. Now under current law, if the owner passed away, the heirs would get the stepped up basis from $500,000 to $1.5 million, and they would not have to pay any tax on the sale at the time that they sold it.
David:
So stepped up basis is really raising the tax cost to those who inherit the property
Mike:
Is the stepped up basis threatened in legislation that's being worked on right now?
David:
Potentially. There are proposals to eliminate stepped up basis. The thought is that the heir should pay the tax on that gain that accumulated through the asset over the years. Even versus estate tax, was highly controversial in ag, understandably. If heirs inherit the property ... The good news is there's a big gain and there's a big asset with inheritance, so it's all relative. But you don't want to be put in a position of having to sell the farm or pay the tax. I don't think that would happen in any case because you wouldn't have to pay the tax at the time of death. It only would be at the time of the sale if stepped up basis were to go away. The reason for the proposal to eliminate stepped up basis is to pay for other programs under the infrastructure bill.
David:
Now, again, there could be carve-outs for farm exemptions for ongoing business owners only when they sell. While this is certainly a critically important topic, our folks in DC have heard directly from senior Democratic members and staff who stated this is not doable. There's no way that they think they can get this accomplished. Again, as I mentioned, there are several farm, ranch state Democratic senators who are swing votes and they will not go along with it. What I'm hearing is that while everything is on the table in terms of proposed revenue raisers for tax purposes, stepped up basis will be extremely difficult to achieve.
Mike:
That's probably good news for farmers that are listening here today.
Mike:
David, as we wrap up here, give us a feel for how people can get a hold of you and what kind of services you can help them with when they consider a 1031 exchange or any of these other topics that we've talked about actually?
David:
Yeah. Well, in order to do an exchange, you have to utilize a qualified intermediary company to handle the transaction. And that's what we specialize in. So if somebody has a sale that they're considering, they want to get in touch with us to talk about their transaction and talk about the details before they sell the property, we handle all the exchange documents that are required under the IRS rules, and we'll walk folks through it from start to finish. We specialize in this. This is all we do. Again, we've been doing it for 20 years and have a real strong specialty in ag and across the country.
David:
Our website is www.ipe1031.com. Again, that ipe1031.com. There's a number of tremendous resources on there, including reference guides and educational resources. I would just encourage people to reach out as they have questions.
Mike:
Do you have a phone number that you could also throw out?
David:
I do, yes. 888-226-0400
Mike:
888-226-0400. David, thanks for your time. This is some great information. And like we mentioned earlier, it's information that folks can probably use right now. We're coming into a time, I think in agriculture when we're seeing a lot of incidents where farmers and farms themselves are being transferred, the ownership is. You have maybe some children of long-time farmers that are not continuing with the agriculture or continuing with the production of agriculture and using the land that way, but are in an investment role, and this is some top-notch information, as I'm sure that you're experiencing with your customers. You're probably seeing a lot of this I imagine.
David:
Yeah, for sure. I would just really emphasize here when you think about the day-to-day stuff that impacts farmers, when you talk about $2.3 billion of transactional activity of 1031 exchanges over five years, in fact most of those the median was $443,000, so this is small to medium farmers. From a day-to-day perspective, the impact on operations ... and our farm realtors have said, "If you take 1031, 25% of transactions go away because people are tax-locked and they can't sell." And when you're considering what are the provisions that impact ag the most, I think that people really dive into it, 1031 comes out on top by a very wide margin.
Mike:
Well, David let's stay in touch. This is a topic that's not going away anytime soon, I'm sure. I appreciate your information and your time today and the way you're trying to help farm families.
David:
It's who we are. Again, thank you for the opportunity.
Jodi:
Thanks to Mike McGinnis for hosting this podcast, to Grasshopper for their sponsorship, and to David Brown for his expertise, and thank you for listening. For Successful Farming, I'm Jodi Henke.