The Exchange Factor

Today's 1031 "tax-free" exchanges are increasingly a part of the agricultural land transaction equation.

During last year's Illinois Farm Bureau (IFB) Association convention in Chicago, delegates haggled for two hours over policy concerning 1031 tax exchanges. Such transactions, named after the section of the federal tax code that allows them, are increasingly being blamed for (or credited with) contributing to the nation's skyrocketing agricultural land values.

IFB spokesman John Hawkins says the debate stems from urban sprawl in Chicago and the “Metro East” of St. Louis, MO.

“Landowners in those areas are selling their operations and going to the remaining rural areas with big bags of money, and paying far more than the land is worth in order to avoid capital gains taxes,” Hawkins says. “It really hurts younger people's ability to get into agriculture.”

Conversely, Hawkins adds, “Older farmers embrace the 1031 exchanges as a tool to boost retirement savings.”

Under these exchanges, property sellers avoid paying capital gains taxes on a sale if they identify “like-kind” property within 45 days, and consummate the “replacement” within 180 days. A sale of property and subsequent purchase of a replacement property won't work, though — it must be an exchange of like property.

A survey released in August by the Illinois Society of Professional Farm Managers and Rural Appraisers found 56% of ag land buyers taking advantage of 1031 exchanges. The price of Illinois ag land increased statewide by 5% during the first half of 2005, and showed no signs of slipping. The increase followed a 20% rise in prices statewide in 2004.

The Internal Revenue Code has allowed for 1031 exchanges since 1921, with the regulations updated several times.

The 45-day and 180-day rules start running from the date of the sale of the first relinquished property. This is strictly enforced, even if the 45th day falls on a holiday.

But, the like-kind property definition is quite broad, says Loyd Brown, president of Hertz Farm Management Inc., Nevada, IA. He's an accredited farm manager, rural appraiser, land consultant and real estate broker in Iowa and Illinois.

“The exchange can include a farm for a farm, improved land for unimproved land, a farm for commercial property, a farm for apartments, a farm for a strip mall, a farm for a car wash, etc., or vice versa,” Brown says. “If the replacement property is retained until the taxpayer's death, the replacement property receives a step-up in tax basis. If the heirs then sell the farm at the same value as in the estate, there's no capital gains tax.”

Laying the blame/credit

Illinois isn't the only state where exchanges are blamed for driving up land prices. In Iowa, 1031 exchanges — sometimes referred to as “tax-free” exchanges — have also garnered much attention.

“In Grundy County, apartments and other property are being exchanged for farmland,” says Mark Buskohl, Grundy Center, IA. “It's added $500 to $1,000/acre to farmland prices.”

A Nebraska Farm Real Estate Survey released last July 1 found “non-farm investors” and 1031 tax exchanges were ranked by survey respondents as the two most influential factors behind the recent rise of land values.

In Missouri, respondents to a University of Missouri (MU) ag land values survey were asked to estimate how much farmland values in their area had changed in the past year. On average, they estimated all types of farmland had increased 10.2%; cropland, 10.6%; pasture, 10%; and other types of farmland, 11.4%.

These 2005 increases are larger than predicted in the 2004 survey, say Ron Plain and Joyce White, MU ag economists.

“Several respondents cited an increase in demand for good farmland by farmers relocating as a result of 1031 exchanges,” the duo said in their report issued last fall. “In addition, loan interest rates remained low, commodity prices and production were high, and strong demand for non-ag uses held.”

The 1031 exchanges are definitely a factor in the farm real estate market, Brown agrees, but not the key factor driving up the market. Use of this provision of the federal tax law has increased over the years, due to more awareness of the tax-free exchange benefits, he says.

“A farmer or landowner is less inclined to sell highly-appreciated land, pay the capital gains tax, and invest the net proceeds into low interest-bearing accounts or into the stock market, due to the uncertainty and risk,” Brown says.

The impacts of 1031 exchanges spill well beyond metro areas, say Jason Henderson and Nancy Novack, Federal Reserve Bank of Kansas City economists.

“Now, farmers close to metro areas such as Kansas City have a tax incentive to sell their farmland and purchase land in western Kansas,” Novack says. “Exchanges have emerged as a mechanism that transforms the rising demand for land near urban centers into a rising demand for land in more remote areas.”

Land purchases for investment or urban use also appears to be driving non-farm demand for land, Henderson says. Since 2002, ag bankers responding to an ag credit survey in the Kansas City Federal Reserve District say investment buys have become the biggest non-farm demand influence on farmland values, he says. More than 70% of the bankers said farmland purchases were driven by investment decisions (see page 22 sidebar).

Trying to change the law

At this year's convention, IFB delegates adopted resolutions recommending the 1031 provision of the IRS code be modified to let property owners buy different types of real estate, not just farmland, says Adam Nielson, IFB issues director. Another calls for relaxing the reinvestment time.

Meanwhile, Farm Bureau delegates in neighboring Iowa adopted a motion to expand the identification and transfer periods to one year. This would allow more time to identify property and perhaps pay less for it. They also want more stringent property categories for real property to qualify for like-kind exchanges, such as farmland only for farmland.

There's already more than one way to structure a 1031 exchange. Regulation changes in 1991 established a set of “safe harbor” procedures. These include use of an intermediary, direct deeding, use of qualified escrow accounts for temporary holding of exchange funds and others.

“It's desirable to structure exchanges to be in harmony with the 1991 regulations,” says Len Roberts, Independence Realty Professionals, Gilbert, AZ. “As a result, exchanges commonly employ the services of an intermediary.”

Exchanges, he says, can also occur without the services of an intermediary when parties to an exchange are willing to exchange deeds or enter into an exchange agreement with each other.

“However, two-party exchanges are rare, because, in the typical 1031 transaction, the seller of the replacement property isn't the buyer of the taxpayer's exchange property,” Roberts says.

The future of ag land

A February 2005 Purdue University survey found Indiana farmland values exceeded $3,500/acre on average this past fall and winter, says Craig Dobbins, a Purdue Extension farm management specialist. Since 2000, each increase in average price per acre of farmland has set a record, he adds. This is attributed to the booming land market, along with development, tax incentives, farm expansion and modest long-term interest rates.

“They're the same factors pushing the farmland market for the last several years,” Dobbins explains. “One is the continued demand for homes in the country, and land for development purposes, like subdivisions or commercial properties.”

Another factor is farmers' desire to buy land to grow their operational size. The 1031 exchanges allow people to sell their property to developers for big prices, then reinvest the money back in real estate without paying capital gains taxes on the transaction.

A final factor is low interest rates. Long-term rates have ceased their decline and are creeping up a bit, though they're still low, Dobbins says.

While some farmers and ranchers complain 1031 buyers represent too many people chasing too little land, others enjoy the attention of investors around the nation, says Mauricio Sanchez, president of Sanchez and Rivera Exchange Corporation, Chicago, IL.

Experts also agree that the drought that has plagued many areas of the country will not have any affect on farmland values, since 1031 exchange buyers typically do not depend on farm income to buy land.

“A downside is 1031 exchanges continue to push cash rents higher, resulting in less income for many producers,” Sanchez says. “Many see this trend as contributing to the shrinking number of small, independently-owned operations.”

Will the interest in farmland subside with or without 1031 exchanges?

Gary Schnitkey, University of Illinois Extension farm management specialist, doesn't see anything stopping the rise in farmland prices in the near term.

“Farmland has outperformed almost all other real estate investments the last five years. There's no indication the trend is ending,” he says.

Farm economy spurs land values

A Federal Reserve Bank of Kansas City survey last spring revealed recreation as an increasingly important influence on demand for farmland. In 2003, more than 55% of the bankers reported recreation as a reason for farmland purchases, up from 45% in 2002.

In 2001, wildlife recreationers spent $12 billion on land leasing and ownership, up from $7 billion in 1996. The bulk was in land ownership.

In comparison, $11 billion was received in government payments by farmers. In 2002, 28,000 farmers reported earning $202 million from recreation services.

While recreational services supplemented income for most farmers, 7% earned more from recreational services than the average per capita income of $23,362 in rural counties.

The full report, “A Resurgent Rural Economy Spurs Farmland Values,” from the Federal Reserve Bank of Kansas City — Economic Review, First Quarter 2005,” can be found at:

Exchanges explained

Andy Gustafson of Old South 1031 Exchange Services, LLC, Destin, FL, is a nationally qualified 1031-exchange intermediary for investment and personal property owners.

He says private and corporate property owners should be familiar with the variety of tax-deferred exchanges, including delayed, simultaneous, reverse and construction exchanges, to “build wealth and save taxes.” He extends his advice to realtors, lawyers, accountants, financial planners, tax advisors, lenders, business brokers, and escrow and closing agents.

He's not sure of the 1031 exchanges' direct impact on ag land values, because they can get very complicated.

“Any property held for investment or used to produce income can be exchanged for any other investment or income-producing property,” Gustafson explains.

This applies to rental homes; apartment and commercial buildings; strip malls and shopping centers; raw land, farmland and timber; unharvested crops; and oil, gas and mineral interests. Even collectibles, if held for investment, as well as livestock, corporate aircraft and ships, tenants-in-common, sale leaseback transactions, leasehold interests and improvements to be constructed can be exchanged.

Property excluded from non-recognition treatment are personal residences; inventory; fix/flips for resale; stocks, bonds or notes; interests in partnerships; certificates of trust; or beneficial interests.

The Internal Revenue Service (IRS) doesn't stipulate a specific holding period for an exchanged property, he notes.

“IRS's position is that if the exchanger's property was acquired immediately before the exchange, the exchanger acquired the property primarily to dispose of it, rather than hold it for productive use or investment,” Gustafson explains.

If the replacement property is disposed of immediately after the exchange, it wasn't held for qualified purposes. Time is one determinant of the exchanger's intent.

“It's suggested the property be held for a minimum of one year and one day,” Gustafson adds. “The shorter the time, the stronger the events must be to substantiate proper intent.”

There's no hard, fast rule. Many believe two years is necessary. The taxpayer must intend to hold property for investment or income-producing purposes when the property is acquired.

“If there's a bona fide intent to meet the holding requirement, the qualified use period may be less,” he says. “The taxpayer should consult with their tax advisors on their particular issue.”

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