Selling the Family Farm or Ranch: What you Need to Know

/
 
straight talk: What you need to know about selling the family farm or ranch

Selling a Farm or Ranch:  What You Need to Know

Selling the family farm or ranch can be a difficult and emotional decision.  It is also one that can trigger complex tax and income issues.  Accordingly, proper planning for life after the sale should begin long before the place is listed.

Many factors can affect your tax bill and, therefore, your financial state after the sale.  Some of the most common are: 

  • Whether you complete a 1031 exchange
  • How your farm or ranch is owned (i.e., individually, partnership, LLC, S Corp, C Corp, etc.)
  • Whether the sale includes a home
  • Whether your ranch consists of multiple separately deeded parcels with different cost bases
  • Charitable giving
  • How and where to invest the sale proceeds 

Whether you and your family receive maximum value for your years of hard work may be determined by if and how you plan for the sale.  This article will discuss some of the most common issues and opportunities when selling a farm or ranch. 

Issue:  You face a large tax bill on the sale of your farm or ranch. 

Selling highly appreciated property can result in a hefty tax bill.  Taxes owed may range from roughly 25% to more than 50% of the sales price, depending on the property’s ownership structure (i.e., partnership, LLC, S corporation or C corporation) and federal and state tax rates.   

Opportunity:  Use the Section 1031 exchange to defer or eliminate tax.

Section 1031 of the Internal Revenue Code allows for the exchange of property for other “like kind” property without it being recognized as a taxable sale.  Thus you can sell your farm or ranch, use the proceeds to purchase other real estate and defer capital gain taxes.  Doing so may significantly increase your cash flow and enhance your wealth, because money that would otherwise be lost to taxes can instead be invested in real estate that generates income. 

Consider this example:  An agricultural couple, both aged 60 with an average life expectancy of 80, sells ranch land in Montana with virtually no tax basis and no debt for $4 million.  Using current capital gain tax rates (20% federal, plus 3.8% Medicare surtax and approximately 5% for Montana state tax), and ignoring any potential alternative minimum tax, depreciation recapture or other tax effects, the tax cost on the sale will be approximately $1,150,000 ($4 million x 28.8%) if no tax deferral strategies are used.

Investing with 1031 exchange vs investing without 1031 exchange

Now, let’s assume this couple instead elects to exchange the entire $4 million of the sale proceeds, as their cash needs are satisfied from the sale of livestock and equipment.  By exchanging the entire amount, they owe no tax -- saving them $1,150,000. 

Thus, they can now put the entire $4 million to work for them, reinvesting into real estate.  Let’s assume that they invest in commercial real estate paying a 6% cash flow return, giving the couple $240,000 of annual income.   (That’s $69,000 more income each year than if they had paid the tax and had only $2,850,000 to invest in commercial real estate.) 

 
incremental cash flow of commercial real estate vs. a ranch operation

Let’s further assume that their ranch operation was yielding a 2% return on equity, providing them with annual net cash flow of $80,000 ($4 million x 2%).  Exchanging property generating a 2% return on equity into property generating a 6% return increases the couple’s annual cash flow before income taxes by $160,000 ($4 million x 4%).  Thus, they are earning $160,000 more each year in retirement than they earned by working the ranch.  

 
outright sale vs. sale with 1031 exchange

Over the long term, the 1031 exchange may also enable them to leave a larger estate for their heirs.  By investing the tax savings, and assuming an annual compound return of 7% (cash flow plus appreciation) on the commercial real estate they purchased with those savings, their $1,150,000 of tax savings could grow to become $4,450,137 (pre-tax) in 20 years. 

 

Additionally, under current law (2018), the deferred tax liability may be eliminated entirely when you die.  Your heirs would inherit the property at its fair market value at the time of your death, and the tax basis on the property would be “stepped up” to that current value.  If they later chose to sell the property, they would pay tax only on any gains above the new, stepped-up basis.  Thus, by employing the 1031 exchange until death, you may not only defer taxes on the sale of your property, but permanently eliminate them. 

Thus, the 1031 exchange is one of the most powerful wealth-building tools available for people selling highly appreciated real estate, such as a farm or ranch.

To learn more about the 1031 Exchange, please read our Straight Talk guide, "Using a Section 1031 Exchange When Selling a Farm or Ranch."  

Issue:  Your farm or ranch is owned by a partnership or LLC; the partners want to go their separate ways after the sale, and one or more partners want to do a 1031 exchange.  

The rules governing 1031 exchanges require that the taxpayer or entity selling the relinquished property must be the same taxpayer or entity acquiring the replacement property -- thus the partnership or LLC would have to complete the exchange. 

Opportunity: With advance planning, you can convert the ownership from partnership/LLC to Tenants-in-Common.  

Prior to the sale, the partnership or LLC could deed the property out of the entity and into the individual partners’ names, where they would hold it as tenants-in-common.  Each individual is then positioned to sell for cash or complete a 1031 exchange upon the sale of the property.   This is commonly called a Drop and Swap.

An important consideration is the timing of the deeding of the property.  You should complete this well before the property sale to reduce any risk of noncompliance with 1031 provisions.

If it is too late to safely perform a Drop and Swap, it may be wise for the individual partners to identify separate replacement properties they wish to purchase as part of their 1031 exchange.  The partnership would close the sale of the relinquished property and complete the exchange into the identified replacement properties.  The partnership would maintain ownership of these properties for a reasonable period of time, and then deed the properties to the respective partners.  This is commonly called a Swap and Drop.

It’s possible that deeding the real estate out of the partnership or LLC could trigger a taxable event.  You should consult your tax advisor before implementing either of these strategies.

For further information about partnership and LLC entity planning for 1031 exchanges, please refer to our Straight Talk guide, "Entity Planning When Selling a Farm or Ranch: Partnerships, LLCs and the 1031 Exchange."

Issue:  Your farm or ranch is owned in a corporation.   

Generally speaking, the biggest problem with owning appreciated real estate inside a corporation is that, unlike partnerships and LLCs, you can’t get it out of the corporation without triggering a taxable event.  This effectively eliminates the partnership strategies of direct deeding to the individual partners. 

Opportunity:  The corporation can perform a 1031 exchange. 

If the shareholders are willing to remain invested together, this can be a simple solution -- the corporation can perform the 1031 exchange into replacement real estate. 

Alternatively, if one or more shareholders want to cash out and go their separate way -- regardless of how much tax they have to pay -- the corporation could buy back the stock from those shareholders.  The other shareholders could remain in the corporation and complete their 1031 exchange.

Further, the 1031 exchange could create a funding mechanism for buying back those stock shares:  cash flow from income-producing commercial real estate.  Thus, if the stock sales took place after the 1031 exchange, the corporation may be able to redeem those shares without borrowing money or depleting corporate cash reserves.

You should consult your tax advisor if you own real estate inside a corporation and are thinking of selling.

For further information on corporate ownership of real estate, please refer to our Straight Talk guide, "Entity Planning When Selling a Farm or Ranch: Corporations and the 1031 Exchange."

Issue:  Your farm or ranch is owned in a C corporation. 

A C corporation adds yet another challenge, because it is a separate taxable entity and therefore pays tax on profits at the corporate level.  Accordingly, if a C corporation sells a property for a gain, it will owe tax.  When the cash from the sale is distributed to the shareholders as dividends, the shareholders will also have to pay tax on the income.  So, effectively, the income from the sale of the property is being taxed twice.  When combining both the corporate and individual taxes, the total tax may exceed 50%. 

Opportunity:  Convert the C corporation to an S corporation.

An S corporation is generally not a separate taxable entity -- it can sell appreciated real estate and generally not owe tax on the sale.  Instead, the gain is passed through to the shareholders, who will be subject to tax on their individual tax returns. To take advantage of this, the conversion to an S corporation must occur at least 5 years prior to the sale.

You should consult your tax advisor if you own real estate inside a corporation and are thinking of selling.

For further information on corporate ownership of real estate, please refer to our Straight Talk guide, "Entity Planning When Selling a Farm or Ranch: Corporations and the 1031 Exchange."

Issue:  Selling a Home Along with the Farm or Ranch.  

Selling a farm or ranch often involves disposing of both business property -- such as land, livestock and equipment -- and non-business property like a home.  While you can use the 1031 exchange to defer tax on the sale of business and investment property, you cannot include your primary residence in a 1031 exchange. 

Opportunity:  Use Section 121 to exclude gain on your home sale.

There is another section of the tax code that will enable you to take cash out of the sale of your home tax-free:  Section 121.  Under this section, the gain on the sale of a primary residence can be excluded for income tax purposes, subject to the following conditions:

  • The home has been used as the primary personal residence for at least 2 of the last 5 years
  • The exclusion has not been used in the past 2 years
  • The exclusion is limited to $250,000 if single or married filing separately, or $500,000 on a joint tax return

You can incorporate vacant land adjacent to your home in this exclusion, if the land has not been used for business purposes. 

Proper documentation is important -- you must substantiate the value of the home separate from the ranch real estate, and should break out the price separately in the purchase and sale agreement. 

Consult your tax advisor if you are selling a home as part of a farm or ranch sale.

For further information, please read our Straight Talk guide, "Selling a Home Along with a Farm or Ranch: Using the Section 121 Exclusion."

Issue:  Your farm or ranch is comprised of multiple separately deeded parcels. 

Generational farms and ranches are often composed of multiple separately deeded parcels with significantly different cost basis figures.  This stems from families having added to their existing acreage over the years while real estate values fluctuated.

Opportunity:  Do proper cost basis planning.

Cost basis planning is a simple, but effective, strategy when selling such a property.  If you want to take some cash out of your ranch sale and reduce capital gain taxes, it is wise to sell for cash those parcels with the highest tax basis, as they will have the lowest associated tax due.  Conversely, those parcels with the lowest tax basis -- and thus the highest capital gain and potential tax -- are the best parcels to 1031 exchange. 

To help avoid potential problems with the IRS, you should have separate purchase and sale agreements for the parcels that will be exchanged and for the parcels that will be sold for cash.  Accordingly, make sure your ranch broker understands up-front what you are trying to accomplish, and do not spring this on a potential buyer after a contract is in place -- they may not agree to restructuring the contract.

Issue:  You face a large income tax bill on the sale, plus high estate tax exposure.  

This is a common problem for some generational farm and ranch families who have decided to sell.  Typically, they have a very low basis in their ranch assets and the real estate has appreciated significantly through the years. The Tax Cuts and Jobs Act, effective January 1, 2018, significantly reduced many families' estate tax exposure by increasing the gift and estate tax exemption to $10 million, or $20 million for married couples. (Going forward, these amounts are to be adjusted for inflation.) Any estate tax value at death above these exemption amounts will be taxed at rates of up to 40%. (Note: These increased exemption amounts are scheduled to revert back to 2017 exemption levels -- $5,490,000 for individuals and $10,980,000 -- as of January 1, 2026.)

Opportunity:  Establish a Charitable Remainder Trust.

A charitable remainder trust (CRT) can be a very effective planning tool for those who own property that has significantly appreciated in value.  This strategy provides several benefits:

  • Eliminates capital gains on the sale of appreciated property
  • Reduces estate taxes
  • Generates an income tax deduction for the donor
  • Potentially provides donor with lifetime income
  • Benefits charities

How it works:  You establish a CRT and transfer appreciated (or depreciated) assets -- such as real estate, livestock and/or equipment -- to the trust, removing the assets’ value from your estate.  The trust then sells the assets and, since it is a tax-exempt entity, there are no taxes due upon the sale.  The proceeds from the sale are then invested in a manner designed to provide lifetime income for the CRT beneficiaries.  Two sets of beneficiaries are established:  (1) the income beneficiaries (usually you and your spouse), and (2) the remainder beneficiary, which is the charity that will receive the principal or “remainder” of the trust after the income beneficiaries die.

By establishing a CRT, you are making a gift in exchange for an agreement to receive an income stream based on the value of the trust assets and the pay-out rate (usually 5-8%).  This gift generates both a federal income tax deduction and, if a resident of Montana, a tax credit of up to $10,000 per taxpayer ($20,000 per married couple) in the year the gift was made. (Montana tax credit data is as of 2018; the credit is due to expire in 2019.)

Since the charity receives whatever is left in the trust when the income beneficiaries die, you may wonder, “What about the children’s inheritance?” 

If you wish to replace for your heirs the value of wealth donated to the CRT, you can establish a wealth replacement trust.  A wealth replacement trust allows your heirs to still receive a cash inheritance.

How it works:  You purchase a life insurance policy held inside an irrevocable life insurance trust (ILIT), with the policy death benefit to be paid to your heirs.  If structured properly, the life insurance proceeds will be free from income and estate taxes.  Since the trust owns the insurance policy, the life insurance death benefit is not part of your estate and, therefore, not subject to estate tax.

The life insurance premiums can often be paid by the additional income provided by the CRT.  A common way to reduce the costs of the life insurance is to use a second-to-die policy.  This type of policy insures two lives -- usually a husband and wife -- and is cheaper than buying separate policies for each individual.  The death benefit isn’t paid out until the second insured person dies, when the estate taxes are typically due.

Issue:  You don’t know where to invest the proceeds from your ranch or farm sale.

Now that you’ve sold your ranch or farm, the biggest question for most folks is how and where to invest the sale proceeds, which may be seven, or even eight, figures.  

Opportunity: Investigate whether commercial real estate meets your needs – but also consider the big picture.

From an investment standpoint, if you think of the four major asset classes being real estate, stocks, bonds and cash, the only asset class that qualifies for a 1031 exchange is real estate.  For many, this fact alone makes their decision much easier, and they will ultimately invest the majority of their sale proceeds in real estate due to the tax deferral opportunities provided by the 1031 exchange.  If you’re looking for cash flow, some type of commercial real estate will generally be your best bet.

However, while the 1031 exchange is compelling, it is also important to consider some of the basic tenets of investing, such as diversification, liquidity and risk tolerance. 

Diversification:  Diversification is a helpful tool for mitigating risk.  To achieve optimal diversification, it’s wise to invest in multiple asset classes.  Some popular asset classes other than real estate include stocks or mutual funds, bonds, and cash instruments, such as money market accounts and certificates of deposit (CDs). 

Thus, some folks will conduct a 1031 exchange for a portion of their sale proceeds, and also take some cash out of their sale, paying the tax in order to then invest the after-tax proceeds in non-real estate investments.  Others will 1031 all of their net sale proceeds, then begin to diversify into non-real estate investments over time with the excess monthly cash flow provided by their commercial properties.  There is no “one size fits all” approach, and people will generally determine what is best for them based on their needs, goals and investment preferences.

Within your real estate investments, it is wise to diversify into multiple properties if possible.  For example, if you can purchase two or more properties, that would enable you to diversify among types of real estate (office, restaurant, medical, retail, multi-family, etc..), as well as by location.  This would give you a more balanced risk profile than if you invested all of your capital into a single property.

Liquidity:  Liquidity simply refers to your ability to access cash to meet your short-term needs and obligations in the event your income sources become disrupted.  Various investments, such as bank accounts, short-term CDs, stocks and mutual funds are able to provide nearly immediate liquidity.  How much cash to keep on hand depends on your specific situation, but a good rule of thumb would be to keep 12 to 18 months of cash available to cover daily expenses and other possible emergencies.

Risk Tolerance:  Real estate investors should have a realistic understanding of their ability to withstand large swings in the value and, maybe more importantly, the cash flow, of their real estate investments.  One thing is certain -- investment risk and return are related.  If one commercial property pays an 8% cash flow return and another pays 5%, there are usually good reasons for this discrepancy and the property producing 8% will carry more risk than the property producing 5%.  It’s up to the investor to decide what is most important to them:  higher returns or security and peace of mind.  If a high-quality property with a strong location in a great market, offering a long-term lease with a strong tenant, will generate enough income for you to live the lifestyle you want, then perhaps chasing higher returns and assuming the related higher risk is not prudent.

For further information on reinvesting the proceeds from the sale of a ranch or farm, click please refer to our Straight Talk guide, “Transitioning from Ag Land to Commercial NNN Leases.”

When a family works generations to build a successful agricultural business, they deserve to reap the benefits of their hard work.  Proper advance planning is the key.  The sale of a farm or ranch is a life-changing event that can trigger complex tax, estate and retirement issues.  If not addressed properly and timely, these issues can cost a family dearly in taxes and lost opportunities -- and inflict unnecessary stress. 

Don’t wait until you have an offer on the ranch before consulting your advisors.  The right time to plan is before the property is listed for sale, while potential issues can be addressed and beneficial resolutions achieved.

 

We’ve provided the information in this Straight Talk guide for general educational purposes.  It is not intended as specific tax or legal advice.  Please consult a professional for specific advice regarding your particular situation.

© 2018 Jack Sauther & Diana Sauther