12 Feb What is a 1031 Exchange and how does it work?
This article was first published in the official magazine of the Tennessee Cattlemen’s Association, Tennessee Cattle Business. It is written by Attorney, Laura Vaught, who focuses her practice on estate planning, general business matters, and property and real estate matters including legal services for farms and agribusiness.
Looking to buy or sell a farm this year? You might consider what is most often called a “like-kind” exchange, or a 1031 exchange after the tax code section that provides for them. 1031 exchanges are tax-free, meaning you can buy and sell similar properties while deferring tax consequences. Here’s a brief look at how they work.
Typically, in order to be taxed on a gain, the tax code requires there to be a realization of a gain and a recognition of a gain. A realization refers to an event that triggers the gain – i.e., you made money that the Internal Revenue Service (IRS) will count as income. For purposes of this article, it would be the amount gained from selling a farm. A recognition of a gain is the act of the IRS taxing that income gained.
Section 1031 is a provision that allows taxpayers to defer the recognition of a realized gain to a later date by exchanging “like-kind” properties. Some characteristics of a 1031 exchange include:
- The exchange must be of like-kind properties, but it is limited to real estate and business properties. For our example here, it would be two farms; however, like-kind is interpreted broadly so it can be most any business or investment real estate.
- The value of the property purchased must be equal to or greater than the value of the property sold.
- Following the sale of a property, you have 45 days to identify a like-kind property to purchase and 180 days following the sale to close on that new property.
- If you receive any cash as part of the exchange, commonly called “boot,” that amount will be taxed. Only the gain or loss from the exchange of real estate will be deferred.
- Reductions in liability are classified as boot. If your debt for the new property is less than it was for the original property, you can be taxed on the difference between those two amounts.
- The exchange can include multiple properties – on either side of the transaction. You can buy multiple properties and sell one, or vice versa. You can also both buy and sell multiple properties.
These are just the basics when it comes to 1031 exchanges. There are other factors to consider, and each situation will have unique circumstances. If you are thinking about buying and selling farms that might work as a 1031 exchange, you should consult an attorney and CPA to help you navigate that process.
Disclaimer: This article is for informational purposes only. It is not legal advice and is not intended to create an attorney-client relationship. It is recommended that you speak to an attorney licensed in your jurisdiction as well as a certified public accountant about your specific circumstances.