BY BILL WINKE
PUBLISHED SUMMER 2008

1031s are a tool anyone can use with any type of investment property. Commercial investors use it. Ag speculators use it. Raw land buyers use it. And for all those reasons, and many more, 1031s are one of the key factors keeping a fire lit under the land boom.

The 1031 Exchange is a much-used method for turning a little into a lot. Understanding how it works is critical to making the best use of this important investment tool.

DEFINITION:

Section 1031 of the Internal Revenue Code states that:

 “… no gain or loss is recognized if property held for productive use in a trade or business or for investment

is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.”

What this means to anyone who invests in rural land is that as long as you roll the profits from one piece of investment property into another, Uncle Sam won’t make you fork over any capital gains taxes right away. In essence, what the government is doing by deferring these taxes is making you a tax-free loan,one you can only invest in another piece of property.

QUALIFIED INTERMEDIARY

The only way to avoid paying capital gains taxes is for the taxpayer never to have actual or constructive receipt of any of the funds involved. That’s where a Qualified Intermediary comes in. This is the individual or company at the heart of your 1031 Exchange.

My lawyer handlesmost of my real estate transactions, and he typically finds another attorney to act as the Qualified Intermediary. But there are literally hundreds of specialized companies set up to serve as Qualified Intermediaries, including ones owned by highly regulated, publicly traded companies. Remember, the Qualified Intermediary does not have to be a local entity to handle this service for you. I’m sure it depends on the market and the complexity of the transaction, but in my experience a Qualified Intermediary gets well under $1,000 for a simple delayed exchange.

Your buyer and your seller must be notified that you are going to perform a 1031 Exchange. They have to sign off on the exchange because they are effectively acknowledging that you have empowered a Qualified Intermediary to act on your behalf in both transactions. You typically make this notification in the purchase so the buyer and the seller are bound by law to cooperate.

CASE STUDY

Let’s say that Honest Abe and Even Steven each have $500,000 to invest in land. Honest Abe decides to grow his holdings by using 1031 Exchanges to buy under-priced properties and sell them fairly priced. Even Steven is going to do the same thing but without the use of 1031s.

Let’s run the numbers. We’ll assume the capital gains tax stays the same over the entire period. We’ll peg this figure at 20 percent: the federal capital gains tax of 15 percent plus an additional 5 percent to approximate varying state rates. During the first five years, each investor will make four transactions, trading up to parcels of greater value each time and selling for a 25 percent gain in each transaction. After four transactions, both hold their final property for a full year and then cash out in the fifth year. For simplicity’s sake, I’m assuming these are all cash transactions. The size of their bottom line would be scary if they financed with just 25 percent down, and their rate of return would skyrocket. I’ll save that for another day.

Round 1:
Both invested $500,000. A year later and $125,000 richer, they both make a move.

Round 2:
Honest Abe makes his first exchange: All $625,000 goes into a new investment. Even Steven takes his gains, pays his taxes, and invests the remaining $600,000.

Round 3:
Honest Abe exchanges again, this time with $780,000. Even Steven tries again and, after taxes, has $720,000 to invest.

Round 4:
Things get ugly as Honest Abe makes another exchange with his bankroll of $977,000. Even Steven pays his taxes on one more sale and invests the remaining $864,000.

Round 5:
In the fifth year, Honest Abe has $1,220,000 to show for his work. That’s a gain of $720,000 on which he’ll have to pay taxes. Even Steven has $1,080,000 but only has to pay taxes on that final $216,000.

Who’ll come out on top?

CONCLUSION:

It’s Honest Abe with a 4 percent margin of victory and $39,000 more in the bank. After taxes, Honest Abe came out with $1,076,000 and Even Steven with $1,037,000. Paying capital gains taxes on each sale cost Even Steven in the long run.

P.S. Yes, these numbers aren’t on the dot. There are costs associated with each transaction, for instance, the fee of the Qualified Intermediary, real estate commissions, etc. 

If you plan to execute a 1031 Exchange, or think you might, be sure to have the appropriate language added to any purchase agreement you enter into regarding the relinquished property and the replacement property.

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BY BILL WINKE

EXCHANGE REQUIREMENT:

The relinquished property (the one you own) must be exchanged for a replacement property (the one you are buying) rather than sold for cash. A Qualified Intermediary uses the proceeds from the relinquished property to buy the replacement property.

QUALIFIED INTERMEDIARY:

A Qualified Intermediary (QI) is the independent party that facilitates a tax-deferred exchange pursuant to Section 1031 of the Internal Revenue Code. The Qualified Intermediary cannot be the taxpayer or a disqualified person.

Acting under a written agreement with the taxpayer, the Qualified Intermediary acquires the relinquished property and transfers it to the buyer. The Qualified Intermediary holds the sales proceeds to prevent the taxpayer from having actual or constructive receipt of the funds. The Qualified Intermediary acquires the replacement property and transfers it to the taxpayer to complete the exchange within the required time limits.

PROPER PURPOSE:

Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify.

The taxpayer’s personal residence does not qualify for a 1031 Exchange.

QUALIFYING PROPERTY:

According to the Federation of Exchange Accommodators (www.1031.org), “Certain types of property are specifically excluded from Section 1031 treatment: property held primarily for sale; inventories; stocks, bonds, or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trusts or beneficial interest; and choses in action. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment.”

TIME LIMITS:

You have 45 days after you close on the the sale of your relinquished property to identify potential replacement properties. If you don’t notify the Qualified Intermediary of the replacements within this time, the 1031 Exchange fails and you trigger the transfer of assets into your name. You are then responsible for all taxes resulting from the sale. Done right, however, and you have 180 days after the transfer of the relinquished property to close on its replacement(s). Keep in mind that the exchange has to take place within a single tax year.

TYPES OF EXCHANGES

Delayed Exchange: The most common type of exchange, a delayed exchange occurs when there is a time gap between the transfer of the relinquished property and the acquisition of the replacement property. A delayed exchange is subject to strict time limits, which are set forth in the Treasury Regulations.

Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs at the same time.

Build-to-Suit (Improvement/Construction) Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.

Reverse Exchange:This is a situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as “parking arrangements” and may also be structured in ways that are outside the safe harbor.

Property Exchange: Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like kind or like class.

TIMING OF 1031 EXCHANGES

An investor empowers a Qualified Intermediary to receive the proceeds from the sale of the relinquished property (the one that’s being sold) and then instructs the Qualified Intermediary to purchase a replacement property. This is the most common form of 1031 Exchange and is called a delayed exchange. A simultaneous exchange is when the Qualified Intermediary sells the relinquished property and closes on the replacement property at the same time.

There’s even a case called the reverse exchange. This occurs when the replacement property is acquired prior to transferring the relinquished property. The reverse exchange was only approved by the IRS in 2000 and requires that the replacement property be “parked” with an entity called an exchange accommodation titleholder, which holds title to the property until the sale of the relinquished property takes place. Two other exchanges exist—the build-to-suit exchange and the personal property exchange—but all of my 1031s have been deferred, and in all likelihood yours will be too.

SHORT-TERM CAPITAL GAINS

What about the taxes you must pay when you finally cash out? The 1031 Exchange is a tax deferral tool, and to defer implies that you will pay later. When you cash out, you will trigger taxes all the way back to the first sale. Some believe that transactions involving properties held for less than a year will be taxed as short-term capital gains even though you used a 1031 to move the proceeds into another parcel.

According to my tax accountant, as long as you hold the final property for at least a year before selling it, you only pay long-term capital gains back to your original basis: the original cost you paid for the first
property. Other accountants interpret this differently. They suggest that you will actually be triggering short-term capital gains on the properties you held for less than a year. My accountant assured me numerous times that this is not true. Be sure to come to a complete understanding of this issue with your own tax accountant before you exchange a property that you have held for less than a year.

DON’T TRY A 1031 EXCHANGE AT HOME

A 1031 Exchange allows you to defer capital gains taxes, but the IRS gets kind of funny when you try to avoid them altogether. That’s why a 1031 Exchange won’t work if you attempt to roll a gain on an investment property (the relinquished property) into an investment that will become your primary residence (the replacement property). Investors occasionally try to use this loophole to eliminate capital gains taxes completely by satisfying the primary residence requirements and then selling their home tax-free. That won’t work. If the replacement property becomes your personal residence, the exchange will fail.

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To me it’s easy to understand how such price appreciation could occur within an hour of an Atlanta or a Portland. But southern Iowa? It’s just one of a dozen hot markets with seemingly little to offer buyers. What’s behind this boom? The answer is easy: hunters.

Hunters have proven that they are willing to drive the market in their quest to preserve a place that enables them to pursue their passion. In many cases, they’re doing it with capital gains they are protecting by using 1031 Exchanges. In some ways, there is a sense of urgency—buyers jockeying around to get the good stuff and stake a claim to the best possible piece of undeveloped land—before it is gone. Here’s what hunters are buying right now and how you can profit from it.

What Hunters Want
Forget about the vast expanses of tillable land. That’s a whole different ball game. Farmland prices are fueled by a completely different set of dynamics: corn ethanol, soy diesel, major multinationals, and commodity pricing. This article is not about agricultural land. What I’m going to focus on is the seemingly worthless recreational land that has very limited income potential. That’s what hunters buy. In some areas, the price of rough ground is now exceeding the price of tillable land for the first time in history.

Don’t believe me? A friend of mine just sold his hunting farm for $3,000 per acre about a month ago while the best pure tillable in this area sells for about $2,300 per acre tops. Areas like Pike County, Illinois, and Buffalo County, Wisconsin, see this regularly. It is most common in regions where the tillable land is mid-grade and the hunting lands are high-profile. That’s because the tillable is based on rate of return and the hunting ground is based on the desire to own it.

Factors To Consider
Not all rural land appeals to hunters. Primary considerations include proximity to like-minded neighbors or sanctuaries (the neighborhood), the composition of the land itself (how it lays), as well as size, access, and control. Possible improvements also factor heavily into a buyer’s decision. Income generation is typically a secondary consideration.

NEIGHBORHOOD. When analyzing hunting land, the neighborhood is the most important factor. It starts with the county. Focus on counties that border those with the highest-profile reputation. For example, some of the best whitetail hunting in America can be found in Houston County, Minnesota. You will generally find better values in neighboring Winona and Fillmore counties.

Now you need to get down to the individual tract. A broker friend of mine likes to categorize neighborhoods two ways: civilized and uncivilized. Civilized neighborhoods are much more attractive. But more than simply looking at the orderliness of the neighboring landowners, it’s important to find out what these neighbors are doing to impact the species in question. This is the biggie. Like-minded management of the resource is the key. Here is how it works.

Game is a shared resource. Every kind of game has an upper limit harvest tolerance before the quality of the hunting begins to suffer. If the neighbors are hammering every deer that jumps the fence, for example, the subject property is not worth nearly as much to a prospective sportsman than one in a management-friendly neighborhood. Also, today’s hunters are much more stewardship-minded than hunters in the past. They want to be able to effect a change in the maturity of the animals they hunt, to be able to maintain numbers compatible with the habitat, and to improve the overall health of the game they hunt. This requires good neighbors. I would much rather own a marginal farm in a great neighborhood than a better-looking farm in a marginal neighborhood.

Proximity to public hunting land is almost always a negative. The only exception is when the public land is obviously hunted very lightly or when the subject property is very small and serves essentially as a jumping-off point for hunting public land.

LAY OF THE LAND. The land has to look good. Here’s an analogy. If a house looks ugly from the road, it’s not nearly as attractive to a buyer even if it is spacious and has the right number of bedrooms and bathrooms. In the same way, the most valuable hunting land looks good relative to local options. Generally, the most attractive land possesses certain features. First is a majority of habitat. I personally like 75 percent timber/cover and 25 percent tillable land or CRP (Conservation Reserve Program) land. It also features terrain relief with ridges and valleys to create an attractive three-dimensional effect that most recreational buyers favor.

Rough topography also has a hidden benefit to the buyer. Acreage in rural land is not determined based on surface area but instead on the projection of the boundary of the property onto a horizontal plane. In other words, the acre count is not a three-dimensional record; it is two-dimensional, even though the property itself is three-dimensional.

Rough land has more actual surface area per taxable acre than flat land. This is why a buyer may sense that a property feels larger than the actual acre count. Terrain is a very relevant factor when analyzing hunting land. The type of habitat on the land is also important, but it only becomes a factor at the extremes. For example, a beautiful stand of mature hardwood timber adds value both aesthetically and financially to the next buyer. Nasty timberland made up of hedge and locust may detract from the value of the land if comparable farms in the area have better-looking timber.

SIZE. The size of the property also matters relative to the ability to manage the resource. For example, in white-tailed deer country a piece of property has to approach 2,000 acres with a mix of at least 60 percent cover before you begin to control your own destiny. With any smaller property, the neighborhood has to be good to enjoy maximum management success.

Size is also important when considering how much hunting pressure a piece of land can sustain. With the right mix of cover and open areas for feeding (again, I favor a 75/25 split), a property that is only 160 acres can accommodate two hunters for an entire season. But if the land is more open, typically it needs to be larger to produce the same quality experience.

ACCESS. For the most part, properties with limited access are worth less than properties with full, convenient access. In many areas, minimum-maintenance dirt roads are common. When the only way in to a property is a dirt road, the property is less valuable. When it rains, those roads are all but impassible—a big negative.

Avoid landlocked parcels like the plague (those properties that don’t include some form of access such as a county road or an easement across a neighbor’s property) unless you really understand the laws of the state regarding this issue and are up for a potential court battle to gain access. It is much better to make your offer on the landlocked parcel contingent on your ability to buy an easement from a neighbor than to buy the landlocked parcel as is.

CONTROL. Nothing is more discouraging for a new landowner than the battle to keep trespassers out of the property. There are two big red flags to look for when determining the potential trespass situation. First, if the previous owners were local (not absentee) landowners, there is a good chance the problem will be minimal. Second, check out the attitude of neighboring landowners. Stop in and talk to a few potential neighbors just to get a feel. Do just what you least want to do: Knock on the door and make a cold call. The reception you get will speak volumes. Will they keep their friends out of your property?

If you have the time and ambition, you can sometimes remedy a bad trespassing problem by simply being on-site often and letting everyone know that the situation has changed. If you can’t make that commitment of time and don’t have someone who can make it for you, it is best to walk away.

IMPROVEMENTS. Unless the property is a high-profile, high-dollar piece of land, you don’t want to spend time and money adding a lodge or cabin. It is too risky. Let the next guy—the end-user—build exactly what he wants, exactly where he wants it. I have seen too many deals fall apart because the potential buyer didn’t really want to pay for an expensive piece of lodging.

Other improvements, however, are critical to maximizing your return. In general, the trail system through the property should be very clean and passable under the widest possible range of conditions. If it isn’t, spend the money to fix it. Boundary fencing is also important. Establish the line and put in any missing fences so the next guy knows exactly what he is buying and has a greater sense of confidence that the neighbors will respect his boundary.

Again, sticking with the whitetail-hunting theme, nice, clean fields are also important. Ideally they are located in secluded locations. The future hunter wants to be able to plant food plots in as close to a true farming manner as possible. That means that you may have to clear a few overgrown fields, smooth them out, and have them professionally planted. That is a big step toward making the property look good and bringing it closer to finished status. Cover is universal; trails and fields sell deer-hunting property.

What Are You Ultimately Selling?
If you are considering an investment in recreational land, would you be happy keeping the particular tract you are looking at? If not, it is probably not a good investment simply because the things that turn you off will likely turn off the next guy.

THE EXPERIENCE. With recreational land, you are not really buying and selling land. You are buying and selling an experience. Keep this in mind. What kind of experience will someone have when hunting the property you are analyzing? Trespassers, contentious neighbors, poor management prospects, fence disputes, poor access, ugly views—they are all big turnoffs.

The best recreational investments have a secluded, natural feel. Remember, the way the place feels—the experience it produces—is the glue that ties all the other factors together. If it doesn’t feel good, walk away. I like it when the hair on the back of my neck stands up when I’m looking at a property. I know I have a winner.

ELIMINATE RISK. Not all recreational land buyers are sophisticated investors. They may not be good at due diligence. The very thought of dropping their life savings on a piece of dirt has them nervous to begin with. On top of that, throw in a few unknowns and it becomes very hard for them to pull the trigger on a purchase. Eliminating risk for the next guy is an important aspect of recreational land investing. Don’t buy something if you have doubts that you can eventually guarantee the experience through your own hard work, diplomacy, or money spent.

Final Analysis
If a tract of recreational ground meets all the criteria I have set out, in all likelihood you’re looking at a BUY signal. Of course, you also need to hit reasonably close to market price. Unless you plan on solving some major problems related to a piece of property—a costly easement issue, for instance—don’t expect to come across deep discounts in well-established markets.

A solid property at, or slightly below, market price is a better investment for an absentee landowner than one fraught with trespassing problems and projects. But if you have time to police the property and take on projects (improvements), you can make a better return by purchasing a diamond in the rough. This approach is a bit riskier and it will take more time, but the potential return is definitely better.

When Bill Winke writes that investors are driving the market for hunting lands “with capital gains they are protecting by using 1031 Exchanges,” what is he referring to? The answer is quite simple: one of the most sophisticated tools available to savvy investors buying and selling real estate.Sell a stock at a profit, and what do you get? A bill from Uncle Sam for the tax on your capital gain. But sell that same stock for the very same profit in your 401(k), and what happens to your tax bill? Uncle Sam postpones it. If you’re comfortable with this concept, then you have grasped the essence of a 1031 Exchange: a method to defer capital gains taxes on the sale of a property by investing the proceeds in like-kind property as detailed in Section 1031 of the Internal Revenue Code. Winke reports that he has already completed one 1031 Exchange this year and has plans in the works for two more. “I spoke with a Realtor recently, and he said that at least one-third [of] his sales involve a 1031. People have money to move …” he says, and clearly they are moving it into hunting lands.Oddly enough, this doesn’t always mean they are reinvesting profits from one hunting property into another. All real estate in the United States is considered to be like-kind as long as each property qualifies for the proper use. Mineral interests, a rent house, perpetual water rights, and hunting land can all be considered like-kind as long as they are being held for investment.These are just a few of the many specifics associated with a 1031 Exchange. Above all, remember these two words: Qualified Intermediary. This term applies to the independent party that actually facilitates the tax-deferred exchange. Anyone completing a 1031 Exchange relies on a Qualified Intermediary to explain the different types of exchanges—simultaneous, delayed, build-to-suit, reverse, and personal property—as well as the requirements for a valid exchange and the specific time restrictions involved.Are you the sort that likes to save a buck and do your own taxes? That won’t work with a 1031 Exchange. The Qualified Intermediary acts as a safe harbor for the funds and protects the investor from taxable consequences. The instant a taxpayer receives the proceeds from the sale of a property—actual or constructive receipt as it is called—any notion of a 1031 Exchange evaporates. Using that earlier analogy of trading stocks, it is now a transaction done outside the protective shield of your 401(k).

If a 1031 Exchange sounds like it might make sense for you and your portfolio, a good place to start is the Federation of Exchange Accommodators (www.1031.org). This professional trade association is made up of Qualified Intermediaries from across the country. Depending on the amount of hand-holding required, a simple exchange could range from $500 to $1,000 per exchange (more elaborate transactions can cost many thousands more). Winke reports that he paid $800 on his last exchange, and in his words, it was well worth it.

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By Gene Koprowski
 
According to a survey released last week by the Illinois Society of Professional Managers and Rural Appraisers, and the University of Illinois, and released by the Illinois Farm Bureau, farmland values have increased by 5.9 percent since January of 2007. Land sold for $9,900 per acre for “excellent quality farm property” during the first two quarters, while the same kind of land sold for slightly more than $5,000 in central Illinois, the survey said.

Only 36 percent of rural properties sold here moved for tax exchange purposes – so called “1031 exchange” properties. Under the federal tax code, section 1031, landowners can swap land with other rural landowners, and defer taxes until later.  The percentage of transactions linked to the tax break is down dramatically from 2005, when 56 percent of farmland properties that were turned over for tax purposes, according to the society’s study.

Those surveyed by the society – owners of farmland throughout this Midwestern state, who are also members of the Illinois Society of Professional Managers and Rural Appraisers  – told researchers that they expect property prices to continue to increase through the rest of the year.

“Near-term troubles in the credit and housing markets notwithstanding, the U.S. population is putting us on the verge of a looming ‘asset shortage’ and significant inflation,” said Jason Hartman, president of Platinum Properties Investor Network, a financial services firm with 10,000 members, which does business in 33 metropolitan statistical areas (MSAs) across the U.S. “That’s good news for real estate owners.”

Hartman said that there is a long-term “prosperity boom” that is changing the real estate investing game forever.  “This will put upward pressure on prices of farmland,” said Hartman, who is based in Newport Beach, Calif.

Another real estate investor, Gene Curtis,  the broker/owner of RE/MAX Unified Brokers in Macomb, Ill., told LandReport.com, that “price is not a concern for a lot of the people I deal with” on rural land transactions. “Developers are purchasing the land.”

In downstate Illinois, where Curtis runs his business, another factor that is driving sales is the interest in big agribusiness in cultivating lands for ethanol production. Smaller farmers, whose costs in seed, fertilizer, and other inputs, continue to rise, are selling land to the agribusiness companies.

“In the next year or two, there could be some more shakeouts there,” said Curtis.

The study by the society supported this theory. “Commodity prices caused by new bio-fuel demands have led to renewed interest in farmland among farmers in the last half of 2006,” according to the new study. “This has helped renew growth in farmland prices.”

Some rural property managers here surveyed by the society are, however, worried that “farmland prices may have reached their peak,” according to the survey.

Cash rents increased to $191 per acre and are expected to continue to grow, reaching at least $212 per acre next year. That will be $43 above 2006 levels, according to the survey.

Interestingly, the overall volume of farmland sold has decreased, slightly, during the first six months of this year, and the volume of land sold is expected to remain steady throughout the rest of the year, according to the study, the Mid-Year Survey.

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