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It seems like I have seen a substantial number of Section 1031 exchanges with my farm clients this fall. Most have been attributed to solar and data center land sales; but there also seems to be an uptick in inherited land sales. For the most part, 1031s are straightforward. But you must be aware of some rules and nuances.

Let's start with an explanation of a 1031 exchange. Section 1031 of the Internal Revenue Code allows taxpayers to defer capital gains taxes when they exchange one qualifying property used in a business or held for investment for another "like-kind" property. The IRS defines like-kind as property of the same nature, character or class even if they are a different grade or quality. Real property is like-kind regardless of whether it is improved or unimproved.

Agricultural land is a bit tricky because it's usually not bare land. There might be buildings, irrigation/tiling, a personal residence and water/mineral rights associated with the land. Another issue commonly seen in agriculture is many exchanges are with related parties.

Agricultural land can be made up of several asset classes such as land, 1250 property and 1245 property. Land can be exchanged for other real property tax-free if the net proceeds and all cash is reinvested in the replacement property. Section 1250 property (buildings -- other than livestock or storage) can be exchanged tax-free for equal or greater 1250 property. Section 1245 assets must be exchanged for equal or greater 1245 property for tax-free treatment. Keep in mind that 1245 property for 1031 exchange purposes no longer includes personal property like tractors or vehicles.

Debt also plays a role in 1031 exchanges. Often, the relinquished land is encumbered by debt. The newly acquired land must have an equal or greater amount of debt than the relinquished property. This may require a discussion with your bank prior to the 1031 exchange to remove debt from the land or to make sure you can acquire debt on the new land of an equal or greater amount.

Timing is critical in a 1031 exchange. The taxpayer must identify potential replacement properties within 45 days of selling the original property. The exchange must be completed within 180 days of the sale of the relinquished property. Funds from the sale must be held by a qualified intermediary and cannot be accessed by the taxpayer during the exchange process.

When you identify replacement property within 45 days of the sale, there are several rules to keep in mind. The two main rules to be aware of are the three-property and 200% rules. The three-property rule allows you to identify three properties regardless of the fair market value. The 200% rule allows you to identify any number of properties as long as the fair market value doesn't exceed 200% of the relinquished property.

Special rules apply when 1031 exchanges involve related parties. The related party definition not only includes family members but also entities with common ownership and certain trusts. These are often scrutinized by the IRS for potential tax evasion. If you do a 1031 with a related party, neither can dispose of the acquired property within two years, or deferred gain becomes taxable. You should also document that the exchange was at fair market value and at arm's length to avoid IRS scrutiny.

Section 1031 exchanges are more complex than most people believe. There are a lot of rules to follow, and one misstep can cause the 1031 transaction to be taxable. Before you jump into a 1031 exchange, talk through the details with your attorney and accountant to make sure it will be a tax-free transaction.

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DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota. Read Rod's "Ask the Taxman" column at https://www.dtnpf.com/….

Rod Mauszycki can be reached at taxman@dtn.com

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