Investment in forestland for recreation, appreciation, development or merchantable timber has its benefits and burdens. One of the biggest burdens at sale is the payment of capital gains tax. With a little planning, the sale of forestland can be structured to defer both state and federal capital gains tax consequences. Internal Revenue Code Section 1031 defines safe harbor provisions to “exchange” the investment property and defer capital gains tax if the investment is transferred to new property.
Utilizing Section 1031, an investor’s sale of forestland abounds with reinvestment opportunities if the transaction is facilitated by a Qualified Intermediary (QI). This third-party facilitator cannot be your broker, attorney, accountant or relative. Engaging a QI before sale will document the exchange intent, create a defensible audit trail, and preserve the right to defer the tax.
In an exchange, the goal is to go even or up in value from the sale of the old or Relinquished Property to the new or Replacement Property. To the extent that the value is not matched, the difference, not the entire transaction, will be subject to capital gains tax. It is possible conduct a partial exchange and take cash or unlike-kind property at the closing without collapsing the tax deferment on the matched portion. Investors have the opportunity to reinvest the value in a variety of new properties. This allows for a diversification of type and location of property.
The existing or old property and the new property must be “like-kind” in an exchange. There is no need for this term to cause confusion for investors not accustomed to handling their forestland sales as an exchange. Investors often assume a literal interpretation of the term and miss the point of the definition encompassed in the code. It simply means that if you sell real estate you must replace it with real estate to satisfy the like-kind test. It can be any kind of real estate and it can be located anywhere in the United States. For example, this can be made up of forestland for rangeland or land and buildings, single family or multi-family rental property, commercial property, or business property used by the investor.
Strict guidelines for timing and identification of the new property must be followed to achieve full compliance with the regulations. Exchanges must be conducted in the same tax year or within 180 days, whichever comes first. If you start an exchange in December, then to take advantage of all 180 days, it is necessary to file for an extension of the tax filing due on April 15th or the exchange will be cut short by the due date of the tax return. Within 45 days of the sale of the Relinquished Property, a list of possible Replacement Property choices must be delivered to the QI. This is the most restrictive aspect of 1031 so knowing what you want before you sell will produce the best results.
Three rules guide the identification of the new property. The most commonly used rule is the Three-Property Rule. It allows the investor to list three properties of any value and acquire any one, two or three of the properties identified. The 200% Rule provides more flexibility for the investor to list any number of properties as long as the value of the listed properties does not exceed twice the value of the old or Relinquished Property. The third rule is called the 95% Rule and removes the restriction for the number or value of the properties listed as long as 95% of the identified properties are acquired. This rule is rarely used because of the risk involved in tainting the exchange if one property fails to be acquired.
It is important to know that the legal ownership or title of the Relinquished Property must be the same for the Replacement Property. The IRS is always tracking the tax identification number of taxpayer or entity and any change in the ownership will result in a red flag and unnecessary tax liability.
Forestland is a solid, practical, easy to understand investment vehicle. The use of a Section 1031 exchange at sale will preserve equity and provide long-term wealth building.
As the year draws to a close, it’s time to take one last look at any opportunities to lessen your individual tax burden. While the best laid plans are done far in advance of the actual event, it may not be too late to initiate a plan to save some serious money.