Using a 1031 Exchange to Invest in Farmland: Rules, Timelines and Pitfalls
Investors who sell appreciated real estate sometimes look to farmland as their next long-term holding. A like-kind exchange under Section 1031 of the Internal Revenue Code can allow them to defer capital gains tax when they reinvest in other real property, including farmland. The rules are strict, though, and mistakes can make the full gain taxable. This guide from Forever Investments explains the basics and the questions to raise with your advisors.
What is a 1031 exchange?
A 1031 exchange lets a taxpayer sell real property held for investment or for use in a trade or business and reinvest the proceeds in other like-kind real property, deferring recognition of the gain. The tax is not eliminated; it is generally carried over into the replacement property and may be due when that property is eventually sold in a taxable transaction. For estate planning purposes, investors often discuss with advisors how deferred gains interact with the rules on inherited property.
Since 2018, Section 1031 applies only to real property. Equipment, livestock and other personal property no longer qualify.
Is farmland "like-kind"?
For real property, "like-kind" is interpreted broadly. Real estate held for investment or business use can generally be exchanged for other such real estate, regardless of type. That means a rental house, an office building or a commercial lot can, in general, be exchanged for farmland, and vice versa, as long as both are held for investment or business use. Property held mainly for personal use, such as a primary residence, or property held primarily for sale, such as lots held by a developer, does not qualify.
Water rights, conservation easements, crops and improvements on farmland raise specific questions about what counts as real property, so they should be reviewed by a tax professional.
The deadlines
- 45-day identification period: within 45 days after selling the relinquished property, the investor must identify potential replacement properties in writing, following IRS rules.
- 180-day exchange period: the replacement property must be received within 180 days after the sale, or by the due date (including extensions) of the tax return for that year, whichever comes first.
These deadlines are not extended for weekends or holidays, except in limited disaster-relief situations announced by the IRS. Because farmland deals can involve surveys, water reviews, environmental checks and tenant negotiations, start searching before you sell.
Identification rules
Investors commonly identify replacement properties under one of these rules:
- Three-property rule: identify up to three properties of any value.
- 200% rule: identify any number of properties whose combined value does not exceed 200% of the value of the property sold.
- 95% rule: identify more, but acquire at least 95% of the total value identified.
Use a qualified intermediary
In a typical delayed exchange, the investor must not receive or control the sale proceeds. A qualified intermediary (QI) holds the funds and handles the exchange documents. Choose an experienced, well-capitalized QI and ask how funds are protected.
Avoiding "boot"
To defer all of the gain, investors generally need to reinvest all net proceeds and acquire replacement property of equal or greater value, replacing any debt paid off with new debt or additional cash. Cash taken out, or a reduction in debt that is not offset, is called boot and is generally taxable.
Direct ownership vs. fund interests
This is one of the most important points for farmland investors. Interests in partnerships, LLCs taxed as partnerships or investment funds are generally not real property for 1031 purposes, even if the fund owns farmland. An exchange usually requires acquiring real estate directly or through a structure the IRS treats as direct ownership. Some investors use tenancy-in-common interests or Delaware statutory trusts (DSTs), which the IRS has recognized as eligible in certain circumstances. These structures carry their own risks, fees and restrictions, so review them carefully with your advisors. For background on fund structures, see Farm Income Fund's guide on how agricultural investment funds work.
Farmland-specific due diligence
A tight 1031 timeline should never mean skipping due diligence. Before closing on farmland, review soils, water sources and rights, drainage, access, existing leases, zoning and agricultural classification, environmental history and the operator's track record. Our guide on how to evaluate farmland before you buy provides a checklist.
Common pitfalls
- Starting the search after the sale, leaving too little time to identify suitable land.
- Receiving sale proceeds directly instead of through a qualified intermediary.
- Buying a fund or partnership interest that does not qualify.
- Taking cash out or reducing debt without planning for the tax on boot.
- Changing how the property is titled between the sale and the purchase.
- Overlooking state tax rules, which can differ from federal treatment.
Common questions
Can I exchange farmland for a rental property later?
Generally yes, because real property held for investment or business use is like-kind to other such real property. Each exchange must meet the rules on its own, so plan each one with your advisors.
A long-term perspective
For many families, farmland is a multi-generational holding rather than a short-term trade. Our earlier article on farmland and generational wealth explores that perspective. Forever Investments offers farmland fund sponsorship, wealth preservation strategies, sustainable asset management and long-term investment planning. Learn more about us or request information.
This article is general educational information, not tax, legal or investment advice, and not an offer to sell or a solicitation to buy any security. Section 1031 rules are complex and fact-specific; consult a qualified tax advisor, attorney and qualified intermediary before selling or buying property.