Leopold Center Question & Answer: What are like-kind exchanges?

Iowa State University's annual land value survey shows that the average price for Iowa farmland reached an all-time high of more than $2,600 an acre in 2004. One reason cited for the increases is expanded use of like-kind land exchanges. We've asked two experts to discuss these exchanges and to provide some insight on their impact.

Q. What are like-kind exchanges and how are they used? What are their impacts on sustainable agriculture?

Neil Harl, Charles F. Curtiss Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University; Member of the Iowa Bar:

For many years, property owners have been allowed to exchange certain types of assets for replacement property that is “like-kind” and avoid paying income tax on part – usually all – of the gain. That feature has made such exchanges popular. The property must be held for use in a trade or business, or held for investment. Principal residences are not eligible and neither are vacation homes – unless held as an investment.

Real estate exchanges are handled differently than personal property, such as machinery or equipment, breeding stock or business vehicles. In a like-kind exchange, any real estate can be exchanged for any other real estate. Thus, farmland can be exchanged for urban real estate; even water rights can be exchanged for farmland, or development rights in farmland can be exchanged for more land – if requirements are met.

The replacement property must be identified within 45 days of the disposition of the property given up, and the close of the transaction must occur no later than 180 days or the time to file an income tax return (whichever date is earlier).

If either party disposes of their property within two years after the exchange, it triggers gain for both parties to the like-kind exchange. Also, one party in a related party exchange is not allowed to “cash out” of their investment in conjunction with a like-kind exchange.

For example, a son sells 160 acres to a neighbor and, within the designated time periods, acquires a replacement quarter section from his mother. It’s a related party exchange and, because the mother cashes out of her investment, it isn’t eligible for like-kind exchange treatment. The gain would be taxable.

A major question is whether like-kind exchanges of property involving farmland boost farmland values.

There’s little objective research on the effect of like-kind exchanges on land values but there’s a perception, held by many, that such exchanges add to the buoyancy of land values. It is arguable that once the 45-day and 180-day “clocks” begin ticking, it puts pressure on those with funds to reinvest to find an acceptable property. Indeed, as the deadline approaches, the party seeking replacement property may be willing to give up part of the tax savings from a like-kind exchange to nail down a replacement tract.

It seems likely that the availability of like-kind exchanges may encourage disposition of property. If the property owner would otherwise have to pay capital gains tax on property relinquished, the expected gain from the exchange would need to be greater to make it a good move. So it may increase the demand for replacement property.

All of this may be exaggerated in times, such as now, when farmland values have enjoyed several years of increases and the stock market (as a major alternative investment, although stock is not like-kind to farmland) has turned in an unimpressive performance.

Loyd Brown, Accredited farm manager, rural appraiser, land consultant and real estate broker in Iowa and Illinois, and president, Hertz Farm Management Inc., Nevada:

When farmers and landowners sell land at a profit, the increase in value above their tax basis is subject to federal and state capital gains tax and minimum alternative tax. An alternative is to complete a tax-free 1031 exchange by acquiring like-kind property. The like-kind property definition is quite broad and 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. 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 is no capital gains tax.

Some of the common reasons to exchange include the opportunity to sell land at a high price for development, consolidating multiple properties into one larger investment, diversifying one large investment into multiple properties, or relocating property when a taxpayer moves or retires. We also have seen families sell the home farm to one of the on-farm children or long-term farm operator giving them the opportunity to own their home farming base. Sometimes sellers exchange into property closer to where they may have moved or retired. Many people completing tax-free 1031 exchanges are not locked into a specific geographic location and are looking over a broader area to find replacement property that meets their investment criteria.

The Internal Revenue Code has allowed for 1031 tax-free exchanges since 1921 with the regulations updated several times. There has been an increase in use of this provision over the years due to the additional awareness of the tax-free exchange benefits, the higher prices being paid for development land and less attractive alternative investments. 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.

Tax-free exchanges benefit sellers and provide opportunities for buyers of real estate. These tax-free 1031 exchanges are definitely a factor in the farm real estate market, but they are not the key factor driving up the land market.