|September 2007||Volume 3, Number 2|
|Table of Contents|
Agricultural Exchange Issues
Many Section 1031 exchanges involve agricultural operations or agricultural components. These exchanges typically include real property and improvements and personal property. The result may be a group of concurrent exchanges in one transaction. The issues which surface are interesting and the following outlines some of these issues.
Real property is not like-kind to personal property, Rev Rul 59-229, 1959 CB 180; Comm v. Crichton, 122 F.2d 181 (CCA5 1941); Oregon Lumber Co. v. Comm., 20 TC 192 (1953). Whether property is real or personal is generally determined by state law, Aquilino v. U.S., 363 US 509, 4 L. Ed. 2d 1365, 1371, 80 S. Ct. 1277, 1285 (1960); Coupe v. Comm., 52 TC 394 (1969), acqd. in result only 1970-1 CB xv, although some exceptions to this general rule may exist. The words “like-kind” refer to the nature or character of the property and not to its grade or quality, Reg §1.1031(a)-1(b). The terms “nature or character”, “grade or quality” and “kind or class”, may sometimes be of little help in determining whether different properties will be considered like-kind.
Many personal property exchanges are undertaken on a daily basis but they substantially differ from real property exchanges. Under the Regulations for personal property exchanges, Reg §1.1031(a)-2, depreciable tangible personal property held for productive use in trade or business is considered to have been exchanged for like-kind property if it is exchanged for property that is either like-kind or like-class. Classes of depreciable personal property are referenced in the examples in the Regulations and are more specifically set forth in the North American Industry Classifications System (NAICS). This system recently replaced the old Standard Industrial Classification (SIC) system.
Examples of personal property exchanges arising in an agricultural context are the following:
The procedure for determining whether the taxpayer may successfully complete an exchange of certain relinquished personal property for replacement personal property would follow the typical inquiry in any personal property exchange. First, is the property of “like-kind”? If that answer is not readily available, is the property of “like-class”? The taxpayer may need to resort to NAICS in the second tier inquiry.
There are additional problems beyond determining like-kind or like-class. The taxpayer may have no intention of acquiring another ranch or farm operation. In that event, the value allocated in the Buy-Sell Agreement to machinery and equipment will be “boot” to the extent the taxpayer is only going to acquire other commercial or investment realty. This results in an inherent tension between the taxpayer and buyer of the relinquished property with regard to allocation of values to the personal property. The taxpayer would like to allocate a negligible value to the machinery and equipment, but the buyer wants to start out with a high value for depreciation purposes.
Another issue arises in the context of livestock exchanges. Cows can be traded for cows and bulls can be traded for bulls. An exchange cannot include steers or heifers which are neutered, since they are inventory. Inventory or property held for purposes of resale is specifically excluded from 1031 treatment.
The timely identification of replacement livestock also is an issue in most livestock exchanges. The issue regularly arises since replacement livestock are typically acquired at auction sales and may not be acquired as part of the purchase of a replacement farm or ranch. If the taxpayer is not able to identify a specific herd of livestock, they are probably best served if they acquire replacement livestock prior to midnight of the 45th day to capitalize on the “deemed identified” rule.
Another potential problem area in these types of exchanges is that of exchanges out of only a portion of the bundle of rights comprising fee ownership. Transactions involving water rights, timber rights, oil, gas and other minerals, and conservation easements are just some examples. The essential inquiry is whether these types of rights are real property interests according to state law in the venue of the exchange.
This problem is exemplified in the case of water rights since some types of claimed water rights are treated by state law as a real property interest. In other instances, especially stored water that is delivered by an irrigation system from a system of dams, is an adjunct of stock ownership in the irrigation system. Acquisition of the stock shares will not qualify as like kind replacement property and care must be taken in allocating value to the shares as part of the real property exchange.
Another similar problem area is grazing rights which are typically appurtenant to ranching operations. Sometimes these grazing rights are part of a long term lease arrangement with another private party or long term permits with Federal or state governmental entities. These grazing rights are generally viewed as real property interests and therefore part of the entire real property exchange. Other grazing rights are based upon membership in a grazing association, typically involving multiple members. The association membership is evidenced by stock ownership in the association and the stock is specifically excluded from1031 treatment by the Code. As in the situations involving the irrigation company stock described above, the exchanger needs to be careful in the allocation of value to the grazing association stock.
An additional problem area is the sale of a personal residence as part of the exchange. Some taxpayers may be tempted to use as much of the Section 121 exclusion as possible to pull cash out of the exchange of the relinquished property or allocate that value to debt payoff. This avenue is not available if the exchanger is a business entity and not the family members who own the company but are given the residence as a benefit of their employment.
Additionally, there is substantial gray area in determining what comprises the curtilage or additional area surrounding the residence which may increase the value. Many times the taxpayer is tempted to include the value of outbuildings in the Section 121 allocation but that application is faulty since the outbuildings are part of the 1031 transaction. Many times it is possible to include with the actual residence a relatively small portion of the surrounding property and value the residential property at a higher per acre rural residential homesite value than the rest of the agricultural land. This allows the taxpayer to allocate more value to the Section 121 portion of the transaction.
The taxpayer really needs to document the reasonable value of the residence to support the value of the Section 121 exclusion since that may be challenged in an audit. This is a problem since, many times, the allocation issue does not come up until the closing date is looming on the horizon and there is no time to obtain a certified appraisal. If that is the case, the taxpayer is well-advised to have some supporting documentation of initial acquisition cost or value of improvements. In some instances an alternative would be to have a knowledgeable realtor at least provide a current market analysis of the residential tract for inclusion in the taxpayer’s files. That is undoubtedly better than nothing at all in the file.
The taxpayer also needs to discuss the Section 121 transaction with their accountant to determine that there will not be some depreciation recapture issues. They may have forgotten they claimed depreciation on some portion of their residence used as the office or some other aspect of the agriculture operation.
One final thing to consider in the area of agricultural exchanges involving personal property as part of the larger real property transaction is the availability of government programs that may provide tax relief on the personal property exchange portion of the deal. An example of this is the current relief afforded livestock producers who have sold livestock due to extreme drought conditions. Those livestock producers are allowed to use a special application of the involuntary conversion provisions of Section 1033 as the basis for a special four year period for the replacement of livestock sold due to severe drought conditions. That replacement period has been recently further extended pursuant to Notice 2006-82. Where the taxpayer qualifies for this type of relief, it may be advisable to do an exchange on the real property and use the Section 1033 rollover for the livestock in stead of a livestock exchange.
In summary, many times an exchange of farm or ranch property presents as a straightforward real estate exchange. As the transaction goes forward, however, many of the issues addressed in this article may rise to the surface. Hopefully the exchange coordinator and other professionals involved in the transaction who are aware of these potential problems will be prepared to keep the taxpayer on the right track.