Avoid taxes on your tobacco buyout payment
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1031 exchanges offer growers a way to delay the tax man.
With the effective date of the Tobacco Transition Payment Program (tobacco buyout) approaching, tobacco quota owners may want to speak with their accountants or tax advisors to review the tax consequences of receiving their payments. In most instances, recipients are going to be taxed at the federal and state capital gains tax rates—which means that up to one-fourth of the payment received could be going back to the government in taxes.
However, Section 1031 of the Internal Revenue Code offers quota owners a means of deferring tax on their buyout payment. Quotas and other agricultural subsidies have been classified as real property, which can be exchanged for other real property under what is commonly referred to as a 1031 exchange. The funds are simply reinvested into the real property and taxes are deferred.
Tobacco Farm Quarterly (TFQ) sat down with Scott Eggleston, in-house attorney for LandAmerica 1031 Exchange Services of Richmond, Va., to discuss how a 1031 exchange works and how it can work with the tobacco buyout.
TFQ: Scott, exactly what is a 1031 exchange?
Scott: A Section 1031 exchange is a means of deferring capital gains tax on the sale of real estate held for productive use in a trade or business or for investment. In a typical exchange, a taxpayer sells real estate they own, referred to as Relinquished Property, and the funds from that sale are held by the exchange company, also called a Qualified Intermediary (QI), until the taxpayer is prepared to purchase a new piece of real estate, called the Replacement Property, at which time the funds are sent by the QI to purchase the Replacement Property. To defer capital gains tax, the proceeds from the sale of the relinquished property must be reinvested in property of “like kind” real estate, which will be used for productive use in a trade or business or for investment.
TFQ: So how does a 1031 exchange apply to the tobacco buyout?
Scott: Simple. The IRS has announced that they will treat tobacco owner quotas as an interest in real estate, which qualifies for 1031 exchange treatment and therefore can be exchanged for other real estate. For many quota owners, this can be a unique means of saving up to 23 percent of their buyout payment from federal and state taxation.
TFQ: At this point, what is the most important issue to consider with a 1031 exchange of a tobacco buyout payment?
Scott: On June 21, the IRS and Treasury Department issued a notice that stated a valid exchange requires a written exchange agreement be established and an assignment of the quota owner’s payment be in place prior to the effective date applicable to a quota owner. This notice further indicated that the effective dates applicable to each quota owner are the earlier of “(1) June 30, 2005, for flue-cured tobacco and Sept. 20, 2005, for all types of tobacco, or (2) the date on which an Owner and USDA enter into a contract for Owner Payments with respect to the quota.” On July 18, the IRS issued a second notice which modified and superseded the June 21 notice. This new notice established an exception if a quota owner was unable to set up an exchange prior to their applicable effective date listed above. The notice established a new effective date of Sept. 16, 2005, for those quota owners. To qualify for this new effective date, the quota owner who receives a payment must remit that payment within five business days to the Qualified Intermediary (if they have set up an exchange) or within five business days of entering an exchange agreement.
TFQ: What is the role of the Qualified Intermediary (QI) in a 1031 exchange?
Scott: The IRS has formed regulations on how a taxpayer must structure an exchange, since the taxpayer or quota owner cannot have control over the proceeds or buyout payment. There are four “safe harbors” by which an exchange can take place, and by far the most utilized one is engaging a QI to execute the exchange. The QI holds the funds during the exchange and provides the documentation, advice and structure to properly execute the exchange to satisfy IRS guidelines.
It is very important to choose a QI that is knowledgeable, secure and financially stable. If a QI provides inaccurate documents or an incorrect structure for the exchange, the quota owner runs the risk of having the exchange fail. But the most important issue is that the QI is entrusted to hold and have exclusive control of the money during the exchange. Quota owners need to take special care to choose a QI that can provide a sufficient guarantee for the money in the exchange.
TFQ: What is “like-kind” property to the buyout payment?
Scott: In real estate exchanges, the term “like-kind” has a very broad meaning. Any real estate is like-kind to any other real estate so long as it is intended for productive use in trade or business or for investment. Since the IRS treats the buyout payments as an interest in real estate, the payments are like-kind to any type of real estate, such as farmland or rental property. However, it is important to note that primary residences for personal use do not qualify as replacement property.
TFQ: I have heard there are specific deadlines to follow in order to purchase property in a 1031 exchange. Can you explain these deadlines?
Scott: There are two deadlines set out by Section 1031 of the Internal Revenue Code that quota owners must be aware of. The first time limit is the 45-day identification period in which the quota owner must formally identify, in writing, the Replacement Property he or she intends to acquire. In a typical exchange, the identification period begins the day the taxpayer closes on the property being sold (Relinquished Property).
The second time limit is the termination date, which occurs 180 days after the taxpayer sells his or her Relinquished Property, which in this case is the date the QI receives the quota owner’s buyout payment. This is the final day of the exchange and the quota owner must close on any Replacement Property by this date or the exchange fails.
TFQ: What if they want to securitize or take a lump sum payment through a financial institution?
Scott: A 1031 exchange can be used in this situation as well. The quota owner should contact both a financial institution and QI to arrange the payment. And they should keep in mind for an exchange to be valid it must be set up prior to the effective date applicable to the quota owner.
TFQ: Do the quota owners have to put the entire amount of the buyout payment into the Replacement Property?
Scott: To get the full tax benefit of an exchange with no recognized gain, quota owners must trade up or even. In other words, to get the maximum benefit, they must purchase a Replacement Property that has a value equal to or greater than their buyout payment.
If the quota owner does not purchase a Replacement Property of equal or greater value, then he or she will probably have to pay tax on the amount that was not invested in the Replacement Property. The Replacement Property can be more than one piece of property, and it is the combined value that is used to meet the equal or greater requirement.