PCCA - Plains Cotton Cooperative Association Logo PCCA Commentator Magazine Masthead. Vol. 36, No. 1 | Spring 2003

Deferring Capital Gains Taxes

Retiring Farmers May Find Investment Opportunities in Business or Commercial Properties

Death and taxes, someone once said, are inevitable. For some, taxes are the most onerous since they seem to impact almost every facet of daily activity. Whether it is sales tax, income tax, property tax, fuel tax, estate tax, or capital gains tax, everyone feels the pinch. For property owners, capital gains tax is a major consideration.

After years of building a significant investment in real property, capital gains taxes can take a huge bite out of any appreciation in value when the property is sold. Such is the dilemma faced by many aging farmers who have acquired land during a lifetime spent tilling the soil and producing important commodities for others. When the time comes to retire from farming, many may feel they have few alternatives. Yet, there is a legal means to defer capital gains tax.

David Pearson

David Pearson, Coldwell Banker Commercial, Rick Canup Realtors

“Generally speaking, a farmer’s taxable gain can be very large if the land has been owned by the family for a long time,” David Pearson says. Pearson, an active farmer and member of PCCA’s Board of Directors, recently became associated with Coldwell Banker Commercial, Rick Canup Realtors as an investment specialist in Lubbock.

Section 1031 of the Internal Revenue Service (IRS) Code provides the only method to defer capital gains taxes that otherwise would be due on the sale of taxable real estate such as farmland. It involves an exchange of like property.

The exchange is a transaction in which a taxpayer is allowed to sell one property and buy another without a tax consequence. It can be done through a simultaneous or delayed 1031 Exchange, and it is the best strategy for the deferral of capital gains tax that would ordinarily arise from the sale of farmland or other real property.

“The 1031 Exchange has been around since the 1920s,” says Bill Lowell, a registered investment adviser and securities dealer in Lubbock, Texas. “It was originally derived for the benefit of farmers to buy and sell farmland without paying capital gains taxes as long as they met certain requirements,” Lowell continues. “For some reason, the 1031 Exchange has never been used to the full extent, but it has received more publicity in recent years.” One reason could be the disappointing performance of the stock market in recent years making real estate investment more attractive.

Just as farming has changed during the past 80 years, so has utilization of the 1031 Exchange. For example, today’s retiring farmers or those wishing to liquidate their farmland holdings for other reasons, are finding investment opportunities in business or commercial properties such as office buildings, apartments, shopping centers, or working oil wells.

“Some farmers may prefer to sell their land and use the 1031 Exchange rather than lease it to another farmer in order to receive a better return, avoid paying annual property taxes and eliminate the worries associated with being a landlord,” Lowell explains. “In addition to a better return, they can get geographic and property diversification.”

“The 1031 Exchange allows a farmer to keep his or her equity intact,” Pearson explains. “In a way, it’s like compound interest because the investor gets to use the money in lieu of paying capital gains tax.”

The IRS Code requires an investor to identify replacement property within 45 days of selling the original property, and the transfer must be completed within 180 days. The IRS also requires the use of a qualified intermediary. After entering into an Exchange Agreement with the intermediary, the seller transfers the farmland or other property to the buyer, the buyer transfers cash to the intermediary, and the intermediary uses that cash to complete the tax deferred exchange.

Bill Lowell

Bill Lowell, Lowell & Company, Inc.

Sometimes, it becomes difficult to locate a property with the right purchase price (100 percent of proceeds from the sale of farmland or other real property must be reinvested, according to the IRS Code) and closing schedule to meet the 1031 Exchange requirements. To avoid such complications, investors can purchase a partial “Tenants in Common” (TIC) interest in commercial property through a professional property management company. Typical replacement properties range from office buildings to apartment complexes as well as shopping centers.

A TIC ownership interest offers many advantages such as:

  • Flexible size to match the investor’s needs
  • Pre-arranged financing
  • Professional property management
  • Potential for increased after-tax cash flow
  • Allows investor access to premium, large-scale properties
  • Easy identification and completion
  • Geographical and property-type diversification
  • Current rates of return at 7 percent to 9 percent

In other words, a TIC 1031 Exchange allows the investor to exchange management-intensive property such as farmland for an institutional-quality property to generate steady income, obtain tax benefits, and appreciation. Income from the replacement property may be more than that received from the original property, and investors can earn substantial cash flow that may be up to 60 percent sheltered by the depreciation on the new basis in the TIC purchase.

Additionally, no capital gains taxes may be due until the replacement property is sold. If the investor dies while owning the property, a stepped up basis will be received by the heirs and the capital gains tax will be completely avoided.

“Investments in office buildings are a good value during a recession,” Lowell says. “The key is to look for areas of high population growth, especially where property is undervalued. Dallas and Austin are good examples at this time because they are buyers’ markets.” The goal of many investment companies is a 15 percent return, and the average actual return on investment is about 8 percent, according to Lowell.

Apartment

Apartment complexes similar to this can be purchased via TIC 1031 Exchange.

“I don’t know if now is the right time to sell farmland,” Lowell adds, “but I do know investment in institutional property provides better financial security at this time.”

One downside to the TIC 1031 Exchange, Lowell notes, is the investor shares the property with other investors, and none can decide unilaterally to sell the property. In fact, during the first three years of ownership, 90 percent of the investor/owners must approve a sale.

“The duration of holdings in commercial or institutional property averages 38 months,” says Lowell. “When the property is sold, the investors can use the 1031 Exchange again to defer capital gains taxes just as they did with their original exchange.”

“You know you’ve made it when you stop selling land by the acre and start selling it by the square foot,” says Pearson.

A 1031 Exchange requires advanced planning, and both Pearson and Lowell advise potential investors to consult with their accountants, attorneys, and financial advisors. IRS regulations also require a Qualified Intermediary to properly complete the exchange.