Opportunity: Use the Section 1031 exchange to defer or eliminate tax.
Written by Jack Sauther CPA, Broker & Principal of Top Hand Realty Advisors, Inc.
Selling highly appreciated property can result in a hefty tax bill. Taxes owed may range from roughly 25% to more than 50% of the sales price, depending on the property’s ownership structure (i.e., partnership, LLC, S corporation or C corporation) and federal and state tax rates.
Section 1031 of the Internal Revenue Code allows for the exchange of property for other “like kind” property without it being recognized as a taxable sale. Thus you can sell your farm or ranch, use the proceeds to purchase other real estate and defer capital gain taxes. Doing so may significantly increase your cash flow and enhance your wealth, because money that would otherwise be lost to taxes can instead be invested in real estate that generates income.
Consider this example: An agricultural couple, both aged 60 with an average life expectancy of 80, sells ranch land in Montana with virtually no tax basis and no debt for $4 million. Using current capital gain tax rates (20% federal, plus 3.8% Medicare surtax and approximately 5% for Montana state tax), and ignoring any potential alternative minimum tax, depreciation recapture or other tax effects, the tax cost on the sale will be approximately $1,150,000 ($4 million x 28.8%) if no tax deferral strategies are used.
Now, let’s assume this couple instead elects to exchange the entire $4 million of the sale proceeds, as their cash needs are satisfied from the sale of livestock and equipment. By exchanging the entire amount, they owe no tax -- saving them $1,150,000.
Over the long term, the 1031 exchange may also enable them to leave a larger estate for their heirs. By investing the tax savings, and assuming an annual compound return of 7% (cash flow plus appreciation) on the commercial real estate they purchased with those savings, their $1,150,000 of tax savings could grow to become $4,450,137 (pre-tax) in 20 years.
Additionally, under current law, the deferred tax liability may be eliminated entirely when you die. Your heirs would inherit the property at its fair market value at the time of your death, and the tax basis on the property would be “stepped up” to that current value. If they later chose to sell the property, they would pay tax only on any gains above the new, stepped-up basis. Thus, by employing the 1031 exchange until death, you may not only defer taxes on the sale of your property, but permanently eliminate them.
Thus, the 1031 exchange is one of the most powerful wealth-building tools available for people selling highly appreciated real estate, such as a farm or ranch.
Top Hand Realty Advisors helps people selling a farm, ranch or other appreciated real estate perform a 1031 exchange into high quality commercial real estate that may provide long-term, stable income. They combine real estate and tax expertise – a unique advantage in helping you meet your specific goals.
Top Hand Realty Advisors provided the information above for general educational purposes. It is not intended as specific tax or legal advice. Please consult a professional for specific advice regarding your particular situation.