Until this point, my blogs have consisted of setting out the benefits of Section 1031 exchanges and the mechanics of the actual exchange. Today I want to address a critical issue regarding the future of tax-deferred exchanges.
SECTION 12504
Many of you do not follow the industry of agriculture very much; I’ll admit it, I don’t either. I live in metropolitan Des Moines, Iowa, which to those of you on the coasts may conjure up images of corn fields and hogs. Those of you in the Midwest, however, know the reality. Yes, we have many farms in Iowa, and yes, they are a vital part of our economy. But the last time I was actually on a farm, was, well, I have no idea. Any time I get on one of the Interstates, I drive past them, but farms are not an integral part of my life. I do deal with them in my business, because farm land is a significant asset and is often a part of one side or the other of an exchange.
So why am I writing about the Farm Bill? Because it contains a little section that could have a major impact on the future of Section 1031 exchanges for all investors, business owners, Realtors®, and anyone involved in the field of real estate. In my blogs, I haven’t yet discussed the concept of “like-kind” in any detail, so I need to address it here at least briefly. To qualify as a proper tax-deferred exchange, real estate must be exchanged for “like-kind” real estate. However, the only real restriction is that the relinquished property (the one the taxpayer is selling) and the replacement property (the one the taxpayer is purchasing) must both be either used in the pursuit of a business or trade OR held for investment. That’s pretty broad, don’t you agree? Raw land can be exchanged for an apartment building. An office building can be exchanged for three single-family rental homes. The only true restriction is that real estate that is not held for investment or used in the pursuit of a business or trade cannot be part of an exchange (e.g., a property purchased with the intent of reselling quickly at a profit, a personal residence, etc.). Section 12504 of the Farm Bill that is currently being considered in the Senate of the United States seeks to change that as it relates to agricultural real property.
Section 12504 would amend the like-kind standard that has been in place for many years to provide that “unimproved agricultural real property” is not like-kind to “improved real property.” In this context, “unimproved agricultural real property” is agricultural land that is enrolled in certain farm subsidy programs, unless the agricultural land is permanently retired from the farm subsidy programs prior to the date of the exchange transaction.
The effect of this would be to prevent taxpayers from exchanging out of, or into, subsidized agricultural land. A farmer who currently owns such land would not be able to exchange into any improved real property, such as commercial, residential, or tenant-in-common (TIC) properties. Owners of improved real property could not exchange into subsidized agricultural land. (This, by the way, appears to be the intended target of this section. Apparently, Congress either believes that too much farm ground is being sold to developers, or that if sales do take place, the Treasury deserves a piece of the action. Regardless of where you stand on those issues, this proposal goes far beyond either of those matters.)
The current theory within the exchange industry on the impact of this proposal is that it will cause farmers who own subsidized land to either hold onto their properties, or to “bite the bullet,” sell without the benefit of exchange transactions, and pay the taxes. It is believed that this will have a significant impact on the exchange industry, the real estate industry, and those who work with TIC properties.
But perhaps most importantly, the proposal creates a precedent that could result in the gradual diminution of Section 1031.
Now, let’s look at this another way. Remember when you played pretend games when you were a child? Let’s play one. Pretend you are a farmer. You are nearing retirement after working a lifetime on your farm that’s been in the family for generations. While you were running your farm (remember, farms are businesses, too), the government offered you a subsidy program. You weren’t wild about the idea, because you were proud and didn’t like the idea of accepting something from the government. Still, you were running a business, so you ultimately made a business decision and accepted the subsidy. Today, for whatever reason (no offspring willing to take on the responsibility, development has reached your doorstep, etc.), you recognize the need to sell your property. Because you inherited the farm forty years ago, you face a monstrous capital gain. But the government has, for many, many years, recognized the validity of the tax-deferred exchange, allowing a taxpayer to move the equity from one investment (the farm) to a new investment without the recognition of a taxable gain, if done properly. You decide that the time has come to sell and move your investment into something that requires a lot less management than your farm. And what does the government do? They tell you that, because you accepted the subsidy that they practically forced you to accept, you can no longer shift that investment into what they now have decided is not “like-kind” 
property. As I searched for an analogy to wrap this up, the one that comes to mind is Lucy telling Charlie Brown that she will hold the football for him to kick, assuring him that she won’t pull it away, and then pulling it away at the last instant to have Charlie Brown end up flat on his back.
What can you do about it? There seems to be a fair chance that President Bush will veto this bill if it reaches his desk, and the Senate does not appear to have the votes to override his veto. So maybe it will be okay. But will it? If Congress has it in their heads that this is a good idea, it won’t stop here. It’s up to us to stop it. If you believe that this is important, write to your Senators and your Congressmen and tell them to pull this section from the Farm Bill. Preserving a taxpayer’s investment and the ability to shift that investment into the vehicle of his choice without tax consequences is as vital to the real estate industry as it is to the taxpayer himself.
Ken Tharp
Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.
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