What is the tax treatment of the farmhouse when exchanging the farm in a 1031?

Your home and its immediate surroundings are a residence, not farm property

IRS Publication 225 says your home is a capital asset and not property used in the business of farming, and that it includes the immediate surroundings and outbuildings relating to it that are not used for business purposes. When you sell a farm that includes the house you occupy, you must determine the part of the selling price and the part of the basis allocable to the home.

That residential part cannot be exchanged, because section 1031(a) applies only to property held for business or investment. It can instead qualify for the section 121 exclusion if you owned and used it as your principal residence for periods totaling two years in the five years before the sale.

Publication 225 works this exact case: a farm sale with the main home, where the gain on the home is excludable under the home sale rules and the gain on the farm business property is reported, partly as recapture and the rest as section 1231 gain. With an exchange, that business gain is deferred instead of reported.

The line between yard and farm follows actual use

Reg. section 1.121-1(e)(1) says section 121 does not apply to gain on any portion of the property, separate from the dwelling unit, that you did not use as a residence. Its Example 1 is a house, a stable and 35 acres: the house and 7 acres were the residence, the stable and 28 acres were used for business, and the gain had to be split between them.

Reg. section 1.121-1(b)(3) adds that adjacent vacant land counts as part of the residence only if you owned and used it as part of the residence and sell the dwelling within two years before or after. Acres you farmed or rented out do not qualify, however close they are to the house.

Allocate the basis and amount realized using the same method you used for depreciation, if any, under Reg. section 1.121-1(e)(3). In practice that means an appraisal that values the house and its homesite separately from the farm, which also feeds the price allocation described in how equipment, livestock and crops are handled.

Worked example: a $2 million farm with a $400,000 homesite

Hypothetical, round numbers; run your own numbers with your CPA. A married couple sells their farm for $2,000,000. The appraisal values the house and two acres at $400,000, with an allocated basis of $150,000, and the 300 farmed acres and machine shed at $1,600,000, with a basis of $400,000.

The $250,000 gain on the homesite is under their $500,000 joint limit, so it is excluded and that $400,000 can be paid to them at closing. The $1,200,000 gain on the farm portion is deferred by sending $1,600,000 to the qualified intermediary and buying at least that much replacement real estate.

Had they run the whole $2,000,000 through the exchange, the house money would have bought investment property and they would have spent a tax-free exclusion for nothing.

• Homesite: $250,000 gain excluded under section 121.
• Farm: $1,200,000 gain deferred under section 1031.
• Cash to the sellers at closing: $400,000, tax-free.

Rev. Proc. 2005-14 covers a house that was both home and business property

Rev. Proc. 2005-14 applies when one property qualifies under both sections, for example a farmhouse you lived in for two of the last five years and then rented to a farmhand. Section 121 is applied to the gain first, and section 1031 then defers the rest, including gain from depreciation, which section 121(d)(6) keeps out of the exclusion.

Boot is also coordinated. Under section 4.02(3) of the procedure, cash received for the business property is taken into account only to the extent it exceeds the gain excluded under section 121, and section 4.03 adds the excluded gain to the replacement property's basis.

The procedure's Example 2, a house used as a residence and a separate guesthouse used as an office, is the closest analogy to a farmhouse with separate business outbuildings. For the general version of this split, see section 121 versus 1031 on a former home.

What to do before listing, and where a DST fits

Order an appraisal that values the homesite separately, write the allocation into the purchase contract, and set up the exchange agreement for the farm portion only. If a hired hand or tenant has lived in the farmhouse for years, it is business property and belongs in the exchange instead.

If you are leaving farming, the farm proceeds can go into passive real estate. Delaware statutory trust interests are treated by Rev. Rul. 2004-86 as acquirable in a 1031 exchange; see traditional DSTs and 1031 for farm and ranch families.

Buying a new home with the excluded proceeds is fine. Buying a home with exchange proceeds is not, as moving into replacement property explains.