Note #2: Sales, Swaps, Bargain Sales, Bargain Swaps!!!
Recap from Note #1
To recap where we were in Note #1, Aunt Sally has a farm. She purchased the farm in 1978, and her cost or “basis” of the farm is $100,000. The value of the farm today is $1,000,000, and assume an easement on the farm is worth $300,000.
The fundamental rule we covered in Note #1 was that under the conservation easement regulations, a portion of the basis of the farm must be allocated to the conservation easement. See Note #1, which is also available under “Links”.
In one of the examples in Note #1, we assumed the local land trust wants to purchase a conservation easement from Aunt Sally for its full value, that is, $300,000. If that happens, Sally will have long-term capital gain of $270,000. But what if Aunt Sally says to the land trust, “I like the idea of an easement on my farm, and I like the fact that you are willing to buy it, but I don’t want to pay tax.” Can you help her?
This is a complicated tax code section, so to keep the discussion simple involves a lot of generalizing. That having been said….
Under Section 1031 of the of the tax code, if you exchange, or “swap,” one parcel of real estate for a different parcel of “like-kind” (more on this below) real estate of equal value, you pay no tax. Technically, tax is “deferred,” that is, you pay no tax when you make the swap of properties. We call these “tax-free like-kind exchanges.” What happens is that your basis in the property you swap becomes your basis in the new property.
Here is an example. Say Aunt Sally has owned an office building in town for many years. Assume the basis of the office building is $100,000, and the value is $1,000,000. If she sells the building, she has $900,000 of long-term capital gain. If she exchanges the office building for, say, an expensive $1,000,000 condo that she plans to use as a rental property, she will not pay any tax but the basis of the new condo will be $100,000, that is, Sally’s basis in the office building. In tax parlance, the basis of the office building “carries over” and becomes the basis of the rental condo. Say Sally sells the condo in five years for a price of $1,250,000. She will have $1,150,000 of long-term capital gain ($1,250,000 sale price minus her carried-over basis of $100,000).
So, again, the swap “defers” tax.
The other very important point under Section 1031 is that the definition of “like-kind” has become very broad over the years. Again, these are generalizations, but, for example, Sally can swap an office building in Memphis for a rental condo in Missoula. She can swap a farm in Georgia for a ranch in Wyoming. She can swap an office building in Memphis for a ranch in Wyoming, or a rental condo in Missoula for a farm in Georgia.
Sale of a conservation easement: “Do I have to pay tax?”
Now we can get to the fun part (at least, some people think this is fun). Under the tax rules, a perpetual conservation easement is treated as “like-kind” property with a fee interest in real estate. This means that, under the tax rules, Sally can swap a perpetual conservation easement on her farm for, say, an office building in town. (There are other requirements under Section 1031, but these are the important ones for purposes of this Note.)
So, back to our example. Sally has a farm, the farm has a basis of $100,000. The farm is worth $1,000,000 and an easement on the farm is worth $300,000. Under the tax rules, then, the easement has a basis of $30,000 (30% of $100,000). If she sells the easement for $300,000, she has $270,000 of long-term capital gain.
What is another option for Sally? She can say to the land trust, “You know, Farmer Brown down the road has some acreage for sale for $300,000. I want you to buy that land from him and I’ll swap you my conservation easement for that acreage.” If that happens, Sally pays no tax at the time of the swap. Her $30,000 basis in the easement “carries over” and becomes the basis in the property she acquired. There are other complicated tax issues that may come up here; check with your tax advisor.
More recap: bargain sale of an easement. We covered this in Note #1, but we should go over the fundamentals again.
To repeat, from Note #1, Aunt Sally’s farm has a basis of $100,000 and is worth $1,000,000. An easement on the farm is valued at $300,000. Sally sells the easement to the land trust for $200,000. This gets a little complicated.
We have determined that the basis of the easement is $30,000. Now, under the bargain sale rules (discussed in Note #1), we know that the basis of the easement must be allocated between the sale portion and the gift portion. Since the sale price of $200,000 represents two-thirds of the $300,000 total value of the easement, two-thirds of the $30,000 basis of the easement, or $20,000, is allocated to the sale portion and $10,000 of the basis of the easement is allocated to the gift portion. This means that Aunt Sally has $180,000 of long-term capital gain (the sale price of $200,000 minus the $20,000 basis of the sale portion). Sally also has a charitable contribution deduction of $100,000, the amount of the value of the easement she gave away by selling it to the land trust for less than its full fair market value. The basis of the easement is $10,000, but that has no tax consequences here.
So, what if Aunt Sally combines her willingness to make a charitable gift (by selling the easement to the land trust for less than the easement is worth) with her desire to pay no tax?
More fun: a “bargain swap” of a conservation easement. Let’s say the land trust is willing to pay $200,000 for Sally’s easement, as in the prior example, but Sally has a better idea.
“Instead of taking your cash,” she tells the land trust, “I want you to purchase that 50 acres of farmland Farmer Brown has for sale for $200,000, and ‘swap’ that with me for my conservation easement.”
Does this work? Yes, this works. Based on my experience, not many people have done this, but only because not many people have done this. Sally will have a charitable deduction of $100,000 for the sale of the easement to the land trust at below fair market value, and she will have no current tax to pay on the $200,000 of farmland she receives in the swap.
Since we have come this far, let’s take Aunt Sally’s transaction with the land trust one step further.
Aunt Sally will pay no tax in a tax-free like-kind swap if she only receives like-kind real estate of equal (or lesser) value for the real estate (or the easement) that she gives up. If she receives cash, in addition to some real estate, she will be subject to tax on that cash. In real estate parlance, cash received in a transaction that is otherwise a like-kind exchange is called “boot.” Very simply put, Aunt Sally may be subject to tax on any boot she receives.
So, let’s go back to the deal where the land trust wants to buy Aunt Sally’s $300,000 conservation easement for $300,000. And let’s say Aunt Sally likes the idea, doesn’t want to pay taxes, but needs some cash. Aunt Sally could say, “I need some cash to pay some bills. How about if you pay me $100,000 in cash and buy $200,000 of that acreage from Farmer Brown and give me that acreage and $100,000 cash for my $300,000 easement?” That works. Aunt Sally is subject to tax on the cash, or boot, she receives, and pays no current tax on the $200,000 “swap” part of the transaction.
And one more for the road
Just in case you are wondering, Aunt Sally could say to the land trust, “Here is the deal I want to do. I like your program, and I want to help you out, so I will give you my $300,000 conservation easement for $200,000. I want $100,000 in cash to pay some bills, and I want you to buy $100,000 of Farmer Brown’s acreage, and I’ll give you my easement for the cash and the acreage. And my tax advisor tells me that if I do it this way, I’ll have a $100,000 charitable contribution, I’ll be subject to tax on the cash I receive, and I won’t have to pay any tax now on the Farmer Brown acreage.”
Sally is right. A colleague once called this a tri-furcated transaction, that is, with three parts: cash that is subject to tax, a tax-free swap for a portion of what Sally receives, and a “bargain-sale” charitable deduction for the value Sally has given up.
Obviously, Sally should not attempt this transaction, and you should not attempt this transaction, without an experienced professional advisor.
In Note #3, coming next week, I will discuss some (but not all) of the issues that come up when considering an easement amendment. One hard and fast rule is that there may not be any hard and fast rules.
Copyright 2014 by Stephen J. Small. All rights reserved.