Introduction
Selling a farm, like selling any business, involves a variety of assets which
may include real estate, equipment, livestock, crops, inventory, and intellectual
property. Investors interested in exchanging a farm for another farm in a
tax-deferred exchange under Internal Revenue Code §1031 need to consider some
complex tax rules due to the mix of real property and personal property.
Investment real estate can be exchanged for any other investment real estate in a
1031 exchange, so, for example, a farm can be traded for an apartment building.
In the personal property arena, however, the rules about what is like-kind make it
much more difficult to match up properties that can be exchanged. In any exchange of
a farm or ranch, the owner must examine what is being sold in order to determine: (1)
if the asset can be exchanged, and (2) what sorts of replacement assets will satisfy
the like kind requirement for a successful exchange.
Conclusion
The first step for an investor thinking of exchanging his or her farm is to itemize
the various assets and determine which of those assets are exchangeable. Real property
and many types of personal property can be exchanged under Internal Revenue Code §1031;
however, assets such as goodwill, stocks, inventory, and covenants not to compete are
not exchangeable.
Exchangeable Assets
Real Estate and Buildings. The real estate assets of a farm include the land and any
improvements affixed to the land, such as a house or shop. Items such as movable fencing,
irrigation systems, or transportable barns that are not affixed to the land may require
analysis by a tax advisor for accurate classification.
If the residential building on the farm is occupied by a tenant, worker, or property
caretaker, that residential building would be considered investment property or property
used in a trade or business and would be exchangeable under §1031. However, if the owner
lives in the house, the building would be considered the owner’s personal residence and not
be exchangeable under §1031. Taxpayers who live in the house on their farm should consult
with their tax advisors about allocating a portion of the total property value to the personal
residence and a portion of the total value to the investment or business property. Even though
sale proceeds attributable to the sale of the personal residence cannot be used in an exchange,
there are various tax strategies involving selling property that is both a personal residence
and investment property. IRC §121 allows individuals an up to $250,000 exemption of gain on the
sale of their personal residence. and married couples can exclude up to $500,000 of gain, subject
to certain requirements. Revenue Procedure 2005-14 clarifies how §121 and §1031 can be used at
the same time in connection with the disposition of the same property.
Crops. Unharvested crops located on land that (i) is used in the owner’s trade or business and
(ii) has been held for more than one year that are sold or exchanged together with the land, at
the same time and to the same person, are considered “property used in the [owner’s] trade or
business.” If these requirements are met, and if unharvested crops are considered real property
under state law, the unharvested crops and the value attributable to those crops would be part of
the real estate that is exchanged for replacement real property. IRC §1231 does not apply if the
investor retains any right or option to reacquire the land the crop is on, directly or indirectly
(other than a right incident to a security transaction). Investors planning to retain a purchase
right to the land should consult with their tax advisors to confirm whether the crops contained
on that land are exchangeable.
Harvested crops are considered inventory and are not exchangeable under §1031.
Exchanging Real Property Assets
Personal property held for productive use in a trade or business or for investment purposes can
be exchanged for replacement personal property that falls within the same asset class or product
class as the relinquished property. The Federal Regulations provide a safe harbor for personal
property in the same asset class. This means that assets falling within the same asset class are
deemed to be like-kind. The asset classes are described in Revenue Procedure 87-56. If the assets
do not fall within the same asset class, they may still be considered like-kind if they fall within
the same product class. Product classifications can be found under Sections 31, 32 and 33 of the
North American Industry Classification System (NAICS), set forth in the Executive Office of the
President, Office of Management and Budget, North American Industry Classification System, United
States, 2002, periodically updated (also called the NA-ICS Manual).
Even if personal property assets are not considered like-kind under the regulations’ safe harbor,
the assets may be considered like-kind for purposes of the exchange if the assets are similar enough
to each other. The IRS provides little guidance as to what types of assets are considered like-kind,
and the minimal case law on this topic is very specific. For example, an SUV has been held to be
like-kind to a passenger automobile, and fishing permits for a particular species and a particular
location have been held to be like-kind to fishing permits for another species and location.
Personal property that is not like-kind under the rules described above cannot be exchanged. For example,
an investor may own a tractor worth $50,000 and an airplane worth $95,000. The tractor can be exchanged
for another tractor, and the airplane for another airplane. However, because a tractor and an airplane
do not fall within the same classification, the investor cannot combine the proceeds of the sale of these
two items to purchase an airplane worth $145,000 and successfully defer taxes on all of his gain.
Livestock. Livestock held for sale in the ordinary course of business is expressly prohibited from being
exchanged. However, livestock held in a trade or business or for investment (i.e. dairy or breeding) can
be exchanged. The like-kind requirements for livestock are very particular. For example, half blood heifers
have been held to be like kind to three quarter blood heifers, but under §1031(e) cows of different sexes
are not considered like kind.
Farm Equipment. Under the NAICS system described above, combines, cotton gin machinery, feed processing
equipment, planters, plows, farm tractors, haying machinery, milking machines, and poultry feeding and
watering equipment all fall under the same product class. Therefore, items within this product class can
be exchanged for each other. For example, a $50,000 combine and a $25,000 plow can be exchanged for a
$75,000 haying machine.
Intellectual Property. Farm owners may own intellectual property assets such as trademarks or trade secrets
as part of their business. Intellectual property is considered intangible personal property and certain types
of these assets, such as copyrights, trademarks, and licenses, may be exchangeable depending on (1) the nature
or character of the rights involved and (2) the nature or character of the underlying property to which it
relates. In other words, in order for an exchange to work, the character of the rights must be the same (i.e.,
a patent for a patent) and the underlying property to which the rights relate must be like-class or like-kind
(i.e., a harvesting machine for a harvesting machine).
Exchanging Personal Property Assets
For multi-asset exchange transactions, identification of replacement property can be tricky. Fortunately,
any replacement property purchased within the 45-day identification period is deemed properly identified.
If an investor cannot close on his replacement property within the 45-day identification period, formal
identification will be necessary. For real property assets, identification of replacement property can
be accomplished with a complete address or legal description, and if acquiring less than a 100% tenancy
in common interest, an indication of the percentage share being acquired. For personal property assets,
each replacement asset needs to be described with as much detail as possible. For example, IRS Regulation
1.1031(k)-1(c)(3) states that, generally, a truck is unambiguously described by stating the model, make
and year. Descriptive information such as a vehicle identification number or a serial number can also
add to a precise description.
Personal property that is considered incidental to other larger personal property or real property does
not need to be separately identified. In order to be considered “incidental” (1) the property must be
typically transferred together with the larger property in commercial transactions (for example the
transfer of a hotel building and equipment and intangible property used in connection with the hotel);
and (2) the aggregate fair market value of all of the incidental property cannot exceed 15% of the
aggregate fair market value of the larger item of property (for example, if the real property portion
of the hotel is worth $1 million, then the personal property value does not exceed $150,000).
Identification
The 1031 exchange of a farm or ranch typically involves more than just a simple exchange of real
property. Provided that the owner determines which types of property are being disposed of and
purchased, these properties can be matched up in accordance with the guidelines and regulations
published by the IRS, and the owner will have a successful 1031 exchange.
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