When it comes to real estate investment strategies, the Internal Revenue Code (IRC) Section 1031 exchange may offer an attractive opportunity for landowners, farmers, or ranchers to maximize real estate investment potential and build wealth.
The 1031 exchange is a powerful tax-advantaged tool that allows for the deferral of capital gains taxes on the sale of real property used for business or investment purposes, including agricultural land. Additionally, all proceeds from the sale may receive a step-up in cost basis should the original investor pass away, bringing the real estate investment up to fair market value. The real estate asset receives a step-up in basis at date of death so that the beneficiary’s potential capital gains tax excludes the appreciation on the property’s value from the date of investment through the date of death.
To illustrate the impact this can have on long-term returns, the following hypothetical scenario compares two common paths: taking sale proceeds in cash (and paying taxes) versus reinvesting all sales proceeds in a 1031 exchange, and deferring taxes.
A farmer purchased a small plot of land many years ago for $100,000 with no mortgage or other debt. Since land is non-depreciable, the land basis remains at $100,000 and they are now selling that property for $1,000,000.
*Source: https://taxfoundation.org/data/all/state/state-capital-gains-tax-rates-2024/
The up-front costs and expenses of an investment in a DST are not reflected in this example.
Cashing Out: The Tax Hit
In the above hypothetical example, if the farmer chooses to take the cash and pay the taxes, they will owe taxes on the net capital gain of $900,000. Together, the federal capital gains tax, state capital gains tax, the NIIT surtax, and potential depreciation recapture result in a tax bill of nearly $300,000, leaving the farmer with approximately $740,000 to reinvest.
Using an Exchange: Full Reinvestment
If the farmer opts to execute a 1031 exchange, the full $1,000,000 in sale proceeds can be reinvested in a qualified exchange tax free. No federal and/or state capital gains tax, potential depreciation recapture, or NIIT taxes are paid at the time of the exchange (assuming all of the requirements of IRC Section 1031 are satisfied).
Long-Term Impact: 10-Year Appreciation
Let’s say the new property appreciates at a modest four percent annually over a 10-year period. In this hypothetical example, thanks to the full $1 million reinvestment via the exchange strategy, it is estimated that the investor will gain nearly $500,000 more in value than the non-exchange path.
Generally, profits from the sale of land will create a sizeable taxable event for landowners. Utilizing the 1031 exchange strategy, owners of real property have the opportunity to delay the tax burden — potentially growing wealth significantly at the same time. Before making any decisions, investors should consult with a tax advisor to understand how an exchange could fit into their investment strategy.