Can I 1031 exchange farmland for a house?

Cropland and a rental house are like kind because both are real property held for investment

Reg. section 1.1031(a)-1(b) says like kind refers to the nature or character of property and not its grade or quality, that improved or unimproved does not matter, and gives the example of a taxpayer who is not a dealer exchanging city real estate for a ranch or farm. The exchange runs the other way just as well. Publication 544 repeats the point: an exchange of city property for farm property, or improved property for unimproved, is a like-kind exchange.

The house has to be held for investment on your side, which means a real tenant paying a fair rent under a written lease. Collect rent, report it on Schedule E and treat the house as the business asset it is. How that holding is shown over time is the subject of how long to rent a replacement before moving in.

The swap also changes your depreciation. Cropland basis never depreciates; once it carries into a house, the building share can be depreciated during the rental years, as farmland into an apartment building explains for a larger building.

A house you will occupy at closing is personal-use property and fails the holding test

Section 1031(a)(1) requires the replacement to be held either for productive use in a trade or business or for investment. Publication 544 lists real property used for personal purposes, such as your home, among the property that does not qualify. A house you move into the week after closing was never held for investment, and the exchange fails on the house.

The same problem follows a house bought for a child or parent who will live there rent-free or at a token rent. Occupancy by a family member counts as rental use only when the rent is real; the Tax Court case that undid a farm-for-houses exchange on those facts is walked through in early inheritance planning with a 1031.

If part of the property will be yours and part rented, only the rented part is replacement property and the rest is cash spent on something that is not like kind; exchanging into a property you will partly live in shows how the split is done.

The rent-first route: two years inside the safe harbor, then move in

Rev. Proc. 2008-16 says the IRS will not challenge whether a dwelling unit qualifies as property held for investment if, for replacement property, the taxpayer owns it for at least 24 months immediately after the exchange and, in each of the two 12-month periods, rents it to another person at a fair rental for 14 days or more while keeping personal use within the greater of 14 days or 10% of the days it was rented at a fair rental.

A dwelling unit under the procedure is real property improved with a house, apartment, condominium or similar improvement, so a farmhouse on its own lot or a lake cottage fits. Whether the rent is a fair rental is decided on all the facts, so document comparable rents when the lease is signed.

The procedure is a safe harbor, not the edge of the law. Moving in at month fourteen because of a job or a parent's health does not automatically kill the exchange, but it turns a published shield into an argument about what you intended on the day you closed.

Worked example: $900,000 of cropland into a $900,000 rental house you move into in year three

Hypothetical, round numbers; rebuild it with your own CPA first. You sell 120 acres for $900,000 with a $150,000 basis and exchange into a $900,000 house, deferring $750,000. You rent it for two years inside the safe harbor, then move in and live there three years, and sell at the end of year five for $1,100,000.

Section 121(d)(10) bars the home-sale exclusion for property acquired in a like-kind exchange sold within five years of acquisition, which the year-five sale clears. Section 121(b)(5) then denies the exclusion for the gain allocated to periods of nonqualified use, the two rental years out of five years of ownership, and section 121(d)(6) denies it for the gain attributable to depreciation taken.

Ignoring depreciation for simplicity, total gain is $950,000. Two-fifths, $380,000, belongs to nonqualified use and is taxed as capital gain. The remaining $570,000 is eligible for exclusion up to $500,000 on a joint return, leaving $70,000 taxed, and the depreciation claimed in the rental years is recognised separately at a rate capped at 25%.

• Deferred at the exchange: $750,000 of farmland gain.
• At the year-five sale: $380,000 taxed for the rental years, $70,000 above the $500,000 exclusion, plus depreciation recapture.
• Sell in year four instead and section 121(d)(10) removes the exclusion entirely.

What to do, and the passive alternative when the house was really about income

Identify the house within 45 days, sign a lease at market rent at closing, keep the rental records for both safe-harbor years, and leave furniture out of the exchange. If the farm you are selling includes the house you live in now, that house is handled under section 121 and not the exchange, as the farmhouse in a farm exchange explains.

Many who ask this want rent, not a house. Interests in a Delaware statutory trust are treated by Rev. Rul. 2004-86 as interests in the trust's real property, so cropland can go into a traditional DST holding apartments or other income property without a tenant to manage, at the cost of an interest that cannot be sold on any public market and can lose value. Heirs weighing the options after a parent's death will find the full set on inherited the farm but not the farming.