Does a farmland DST pay cash rent or crop share?

The ruling's lease is a net lease with fixed rent, and that is the pattern a farmland trust copies

In the facts of Rev. Rul. 2004-86, the property comes into the trust already subject to a ten-year net lease. The rent is a fixed amount that may be adjusted by a formula no party controls, and it is not contingent on the tenant's ability to lease the property or on its gross sales or net profits. The tenant may sublease, which is how a farm operator ends up on the ground.

The trust is classified as a trust rather than a business entity because, under Reg. section 301.7701-4(c), an investment trust with a single class of ownership interests is a trust only if there is no power under the trust agreement to vary the investment of the holders. Let the trustee renegotiate the lease or the debt, or make more than minor modifications, and the ruling says the arrangement becomes a business entity instead.

The holding is what matters to a farm seller: a taxpayer may exchange real property for an interest in the trust without recognizing gain under section 1031, provided the other requirements are met, because the beneficial owners are treated as owning undivided fractional interests in the land.

A crop-share lease moves harvest and price risk onto the landlord, which is the wrong direction for a passive trust

Under a crop-share lease the landlord takes part of the harvest instead of a cheque. Publication 225 says you include crop-share rent in income in the year you convert the shares to money, and that a landlord who does not materially participate reports it on Form 4835 and carries the result to Schedule E. The landlord's income rises and falls with bushels and prices.

A trustee bound by the ruling's facts has none of a landlord's levers. It may not renegotiate the lease or bring in a different tenant except on the tenant's bankruptcy or insolvency, it may make only minor non-structural modifications, and between quarterly distributions it may hold cash only in obligations that mature before the next distribution date. A rent that varies with each season's crop sits uneasily beside a trustee that cannot act on the season.

Whether a share-of-crop formula could ever count as a fixed amount adjusted by a formula is a question the ruling does not answer, and no later guidance was found that does. The practical result is that trusts marketed to exchange investors use cash leases, often with escalators or index adjustments that satisfy the formula language. Land you already cash-rent qualifies for the exchange on the same footing, as cash rent as investment use explains.

What a beneficial owner actually receives, and the risks that come with it

Because the ruling treats each owner as holding an undivided interest in the land, the operator's rent flows through to the owners after the trust's expenses, and each reports a share of income and deductions. The rent is not self-employment income: section 1402(a)(1) excludes rentals from real estate unless the owner materially participates in producing the commodity, and a beneficial owner has no role in production at all.

The structure removes management and it also removes control. An interest in the trust has no public market, there is no right to make the trustee sell, the operator is a single tenant on a single lease, and the value of the acres can fall with land prices, water or a tenant default. Loss of some or all of the invested principal is possible.

If the operator stops paying, the trustee's remedies are the lease's remedies, and a replacement tenant is possible only in the bankruptcy or insolvency case the ruling allows.

Worked example: a quarter section of cash-rented ground into a farmland trust

Hypothetical, round numbers, to be reworked with your own CPA. You own 160 acres you cash-rent to a neighbour, worth $1,600,000 with a $300,000 basis. You sell, send the full $1,600,000 through a qualified intermediary and acquire beneficial interests in a trust that holds a larger farm leased to an operator under a fixed-rent lease with a scheduled escalator.

The $1,300,000 gain is deferred because you reinvested the whole price in like-kind real property held for investment. Your old basis carries into the trust interest, and land does not depreciate inside a trust any more than it did in your name.

What changed is the shape of the income. Your neighbour's rent was renegotiated every year or two; the trust's rent is set at closing and moves only by its formula. If corn prices double, your income does not. If the operator's margins collapse, the rent is still owed, but by the only tenant there is.

• Sale price $1,600,000; basis $300,000; gain deferred $1,300,000.
• Replacement: beneficial interests in a trust holding farmland under a fixed-rent net lease.
• Income after the swap follows the lease formula, not the harvest.

Questions to ask before day 45, and the other places farm proceeds can go

Ask who the operator is, how long the lease runs against the trust's expected hold, how the rent adjusts, whether water rights and improvements are inside the trust, who carries crop and property insurance under the lease, and what the trust may do when the lease expires. The ruling's limits mean the answers are fixed at closing.

A farmland trust is one option among several for land proceeds. Sellers who are done with agriculture often move into trusts holding apartments, medical or industrial property through a traditional DST, buy income-producing land directly as described on the farmland property page, or trade dirt for a building as covered in farmland into an apartment building. The farmland sellers page walks through the whole decision.