A 1031 exchange (also known as a “like-kind exchange”) allows a forest landowner to save taxes by exchanging timberland (or possibly timber) the landowner currently owns for other real property.
Forest landowners who own appreciated timber or timberland are prime candidates for a 1031 exchange as it defers a forest landowner’s tax bill into the future when they eventually dispose of the new real property in a taxable transaction.
What is a 1031 Exchange?
A 1031 exchange gets its name from § 1031 of the Internal Revenue Code where the mechanics of the exchange are explained.
§ 1031 generally provides that no gain or loss is recognized if real property held for business or investment use is exchanged solely for other real property of like kind to be held for business or investment use.
An example will help clarify how a 1031 exchange works:
1031 Tax Savings Example
Larry Landowner owns a parcel of farmland (Parcel A) with a fair market value of $250,000. Larry purchased the land for $50,000 ($50,000 is Larry’s adjusted basis in the land).
Fred Farmer owns a different parcel of farmland (Parcel B) with a fair market value of $250,000. Fred purchased his land for $200,000 (his adjusted basis in the land is $200,000).
Fred and Larry decide to exchange land pursuant to a § 1031 exchange and are happy to simply swap land since both parcels have the same fair market value of $250,000. Neither recognizes any gain or loss on the exchange.
Their adjusted basis in the new land is the same as their adjusted basis in the land they gave up. Larry now owns Parcel B and has an adjusted basis in Parcel B of $50,000. Fred now owns Parcel A and has an adjusted basis in Parcel A of $200,000.
Unlike the example, most 1031 exchanges use an intermediary or broker who helps find a suitable replacement property, as it can be difficult to find someone else who wants to swap properties on your own.
Also, the definition of “like kind” is broad in the real estate context. The type of real estate doesn’t have to be similar…it just has to be real estate. For example, farmland could be exchanged for an apartment building or a single-family home (held for investment purposes) could be exchanged for an industrial property.
The sales and swap of both properties do not have to occur simultaneously. You must find a replacement property within 45 days and close within 180 days of selling your property.
Also, cash or other property (called “boot”) is often received in a 1031 exchange if the fair market values of the property aren’t equal. An individual generally has to pay tax on the value of the boot received, meaning the exchange won’t be entirely tax-deferred like a pure swap.
1031 Example with Boot
Same as the prior example, except that the fair market value of Fred Farmer’s Parcel B is $200,000 instead of $250,000. In order to do the exchange with Larry, Fred offers to pay Larry $50,000 cash (boot) in addition to swapping parcels. Larry accepts the offer and the exchange occurs.
Larry must pay income tax on the $50,000 cash boot received. His adjusted basis in Parcel B is $50,000. Fred’s basis in Parcel A is $200,000. Fred owes no immediate income tax because he didn’t receive boot.
1031 exchanges are reported on Form 8824.
Can Timber Qualify for a 1031 Exchange?
Timber or timberland may qualify for a 1031 exchange depending on what exactly is being exchanged. A forest landowner can either sell the real property (land + standing timber + any other land improvements) or he can sell timber rights (the right to cut the timber) while still maintaining ownership of the land itself.
Generally, exchanging timberland for other timberland or land will qualify for a 1031 exchange. Also, exchanging timber rights for other timber rights may qualify depending on whether the rights are sufficiently similar in duration and extent of rights.
However, exchanging timber rights for timberland itself or other real property generally will not qualify for 1031 treatment based on current law because the IRS does not consider timber rights and timberland to be sufficiently “like kind.” Some exceptions may exist, such as long-term timber rights (30 years or more) in certain states.
Conclusion
A forest landowner contemplating a like-kind exchange should seek professional advice as the rules for 1031 exchanges can be tricky, especially when they involve timber. 1031 exchanges are a powerful way for forest landowners holding appreciated property to defer taxes, but the law must be followed carefully to avoid losing the tax deferral benefits.
Considering a like-kind exchange? Contact Andrew for more information and to make sure you properly follow the 1031 exchange requirements.
