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IRC Section 1031 Exchange: A Powerful Financial Tool for Wyoming Ranchers

Written by Christ Nolt

The Internal Revenue Code (IRC) Section 1031 exchange is one of the most powerful tax saving and wealth building tools available for families selling highly appreciated farm or ranch land. A properly structured 1031 exchange allows a family selling a farm or ranch to sell land, to reinvest the proceeds in other real estate, and to defer capital gain taxes.

Potential benefits of a 1031 exchange include tax deferral, improved return on investment, elimination of active management and wealth building. Each of these benefits is described more below.

Immediate and indefinite tax deferral

In a properly executed 1031 exchange, capital gain taxes are deferred and transferred to  “replacement property.”  Tax is not due until the taxpayer sells the replacement property without utilizing a 1031 exchange.

Since there is no limit to the number of exchanges a taxpayer can complete, it is possible to defer the payment of tax indefinitely.

The 1031 exchange is commonly referred to as a tax “deferred” exchange, implying that taxes are not eliminated, only deferred until the replacement property is later sold in a taxable transaction.  However, it is possible to potentially eliminate capital gain taxes altogether on the sale of property by exchanging into and holding property until death. 

Under current tax law, heirs of a descendant’s property receive a “step-up” in basis of the property’s tax basis to its fair market value upon death.  This step-up in basis could conceivably enable the heirs to inherit property and then sell the property for fair market value soon after the decedent’s death and pay little or no tax. 

Thus, by employing the 1031 exchange until death, it may be possible to not only defer taxes on the sale of property but permanently eliminate them.  Some refer to this strategy as “swap until you drop.”

Returns and management

A typical farm or ranch has a very low cash flow rate of return. 

By selling and exchanging land into other types of commercial real estate, such as office buildings, a family may be able to increase their annual cash flow rate of return, thus garnering an improvement on their return on investment over the agricultural land.

At the same time, exchanging farm and ranch land into investment properties that are professionally managed may enable a family to enjoy passive income, rather than maintaining active management of a farm or ranch.

Wealth building

The greatest potential benefit from using a 1031 exchange may be the ability to preserve all of the equity in the relinquished property. 

Deferring taxes on a sale allows the seller to reinvest the full sales proceeds, undiluted by tax. The ability to invest the money that would have gone to taxes in additional real estate may enable a family to grow wealth and generate more income for retirement.

Consider the following example.  A Wyoming couple sells land that is owned in joint tenancy for $5 million with a cost basis of $500,000.  If the couple were to cash out, they would owe capital gain tax of approximately $900,000.

If this same couple were to do a 1031 exchange on the full $5 million sale, this $900,000 could be invested in additional real estate.  Assuming the real estate grew at an average annual compound rate of seven percent, accounting for income plus appreciation, in 20 years, this $900,000 would be worth approximately $3.6 million.

Not only would this couple benefit from the additional income the real estate would generate while they are alive, if they hold the property until they die and if real estate continues to receive a step-up in basis upon death, they could potentially pass close to $4 million more to their heirs.

There are complex rules and strict time parameters for completing a successful 1031 exchange. For more information, request our Wealth Guide on 1031 exchanges by calling 406-582-1264 or visit solidrockwealth.com and solidrockproperty.com

Chris Nolt is the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families throughout the country who are selling a farm or ranch and transitioning into retirement. Nolt helps families to save tax on the sale of their farm or ranch and create passive income from the sale proceeds.