PD 2026: 1031 Exchange Reform (National)

Like-Kind Property

A like-kind exchange (commonly referred to as a 1031 exchange – a nod to its home in Section 1031 of the U.S. Internal Revenue Code) is a provision in U.S. tax law that allows a taxpayer to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds of such a sale into a new “like-kind” property.

 

Like-kind properties are properties of the same nature or character, even if they differ in grade or quality, or class. While the definition of “like-kind” has been altered over the years as the tax code has evolved, the current rule of thumb is that essentially all real property in the United States held for investment or productive use in a trade or business is like-kind property, and is therefore eligible to be part of a 1031 exchange. Before the Tax Cuts and Jobs Act (TCJA) took effect in 2018, many other forms of personal property also qualified for 1031 exchanges, including machinery & equipment, vehicles, livestock, and more, albeit under stricter “like-class” rules. While the breadth of what qualified for a 1031 exchange was broader, there were tighter regulations on what exactly could be exchanged in return for specific types of property. For example, if you were to complete a 1031 exchange involving livestock, you were only allowed to receive livestock of the same species and same sex in return. This contrasts with today’s approach, where the breadth of what qualifies for a 1031 exchange is strictly limited to real property, but there is no requirement it be of a like-class.

 

The TCJA also increased bonus depreciation from 50% to 100%, meaning the entire cost of a qualifying asset could be deducted in the year it was placed in service. Qualifying assets include things like machinery, equipment, purchased livestock used for specific purposes, and more. Notably absent from the list of assets that qualified for bonus depreciation, however, was real estate. Originally slated to sunset out of the tax code, decreasing by 20% each year from 2023 – 2027, the One Big Beautiful Bill Act eliminated the sunset provision, making 100% bonus depreciation a permanent fixture. 

 

There is no current requirement that real property be used in a certain way (outside of the requirement that it be held for investment or for productive use in a trade or business) by either the seller or the purchaser to qualify for a 1031 exchange – for example, there is no requirement that a purchaser of agricultural land actively farm the acquired property.

 

Mechanics of a Like-Kind/1031 Exchange

If a taxpayer’s transfer of property in a 1031 exchange includes the receipt of money before they are to receive their replacement property, they must utilize a qualified intermediary. If the taxpayer receives any cash from an initial sale of property – even if they intended to immediately use that cash and purchase a like-kind property – the 1031 exchange is invalidated, and the sale is deemed a cash sale. This requires gain to be realized and taxes to be paid, negating any benefit that would have been received under a 1031 exchange. A qualified intermediary is a person or business who enters into an agreement to facilitate the sale of the initial property, holds any cash proceeds from the initial sale in an escrow account, and utilizes those funds to facilitate the purchase of a like-kind property on behalf of the taxpayer. This arrangement ensures the taxpayer never receives, actually or constructively, any cash or benefit thereof, and maintains the integrity and validity of the 1031 exchange.

 

Once an initial property is transferred, and the 1031 exchange window is opened, the taxpayer has 45 days to identify the property to be received – the “replacement property” – or a number of potential replacement properties. A taxpayer can identify (1) up to three potential replacement properties of any value OR (2) any number of replacement properties whose value does not exceed double the fair market value of the property (or properties) to be given up by the taxpayer as part of the exchange. This timeframe is referred to as the “identification period.”

 

The replacement property must be received by (1) the 180th day after the taxpayer transfers their original property OR (2) the due date of your tax return, including extensions, for the year in which you transferred your original property – whichever comes first. 

 

Calculating the Tax Basis of Replacement Property

The taxpayer simply receives the same basis in the replacement property – the property they receive as part of a 1031 exchange – as they did in the initial real estate that they transferred as part of the exchange. 

 

Example: A taxpayer transfers real estate held for investment with a market value of $100,000. Their tax basis in the property they transferred was $50,000. The taxpayer receives in return real estate with a market value of $100,000. The taxpayer’s tax basis in the replacement property is $50,000 – the same as the basis they held in their initial property.

 

If the taxpayer pays any cash on top of the property they transferred (this cash being referred to as “the boot”), there is still a valid 1031 exchange, but the basis in the replacement property slightly differs. The basis of the replacement property now becomes the same basis that the taxpayer held in the initial real estate that was transferred as part of the exchange PLUS the amount of the boot (extra cash).

 

Example: A taxpayer transfers real estate held for investment with a market value of $100,000 as well as an additional $25,000 cash as part of the exchange. Their tax basis in the property they transferred was $50,000. The taxpayer receives in return real estate with a market value of $125,000. The taxpayer’s tax basis in the replacement property is $75,000 – their tax basis of $50,000 in the initial property PLUS the value of the cash paid as part of the exchange ($25,000).

“Actively Engaged in Farming Activities” and “Material Participation” Definitions

The Farm Service Agency (FSA) requires participants in their programs to provide significant contributions to the farming operation to be considered “actively engaged in farming.” Their contributions must consist of a combination of: (1) Capital; (2) Land; (3) Equipment; (4) Active Personal Labor; and (5) Active Personal Management. Contribution requirements and levels can differ based on the structure of the farming operation. Such requirements can be read about at: https://www.fsa.usda.gov/tools/informational/payment-eligibility/actively-engaged-farming.

 

As far as “material participation” goes, the IRS has seven tests, of which a taxpayer need only pass one to have their activity considered “non-passive,” or “material.” These seven tests are:

  1. 500-Hour Test;
    • Participating in the activity for more than 500 hours over the past year.
  2. Substantially-All Participation Test;
    • The taxpayer doing all, or almost all, of the work in the operation.
  3. 100-Hour + More Than Anyone Else Test;
    • The taxpayer has participated in the activity for more than 100 hours over the past year and no one else participated more than the taxpayer.
  4. Significant Participation Activity (SPA) Test;
    • The taxpayer participates in the activity for more than 100 hours over the past year, it is deemed a “significant participation activity,” and the taxpayers combined participation in all “significant participation activities” exceeds 500 hours for the year.
  5. Prior Five of Ten Years Test;
    • The taxpayer has materially participated in the activity for any five of the previous ten years, OR they are a retired or disabled farmer and materially participated for five of the eight years directly preceding their retirement or disability.
  6. Personal Service Activity Test;
    • For personal service businesses (healthcare, law, accounting, etc.), the taxpayer materially participated in any of the three previous years.
  7. Facts and Circumstances Test
    • The taxpayer participates in the activity for more than 100 hours over the past year, and their involvement in the activity is “regular, continuous, and substantial.”

 

Discussion Questions:

  1. Have you ever used a 1031 exchange when selling assets of your farming operation?
  2. What do you feel the impacts, if any, would be if purchasers of farmland under a 1031 exchange would be required to actively farm the property?
  3. Do you feel current tax laws allow orderly planning of / transitioning of agricultural assets to the next generation?