Source: BloombergTax
In the US, the federal tax code can benefit owners of businesses such as wineries and vineyards under a real estate investing tool known as Section 1031 exchanges. But another section of the tax code may be even more beneficial—and less restrictive—for both sellers and buyers.
According to Section 1031, there’s no recognition of gain—and thus no federal capital gains taxes to be paid—when real property that is held for productive use in a trade or business or for investment is sold or exchanged in a 1031 exchange or similar program.
Such replacement property under Section 1031 must be identified in writing within 45 days of the sale of the relinquished property, and closure of the replacement property must occur within 180 days from the sale of the relinquished property.
Beyond the burdens implicit in a 1031 exchange, there are the real-world challenges of identifying one or more replacement properties in a very short period and having the ability to close on these replacement properties within 180 days, without exception.
In a tough real estate market with less-than-optimal capitalization rates, this identification and purchase timetable mandate can make compliance difficult. Any deviation from Section 1031 will lead to capital gains taxes to be paid in full in the same tax year as the vineyard, winery, or other investment property is sold.
A more entrepreneurial—but still legal—approach to the sale of vineyards, wineries, and other investment properties is the installment sale method under Section 453. In an installment sale, the property owner sells to the buyer in exchange for a note—a promise to pay to the seller a combination of principal and interest over a period of years.
Here, we’re talking about sellers who don’t need the bulk of the sale proceeds immediately or in the year of the sale. Section 453(b)(1) states that the term installment sale “means a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.”
What does everyone get out of an installment sale? The buyer receives the property—the winery, vineyard, or other highly appreciated asset, as well as the goodwill, intellectual property, and other features beyond the real estate. This is a key difference between what’s permissible under Section 453 and what’s acceptable in a 1031 exchange.
The seller receives a note promising to make periodic payments of principal and interest to the seller. And just like other types of notes such as mortgages, if the buyer defaults, the seller can retake the property, regardless of how many payments were made prior to the default.
From a tax accounting standpoint, the seller will receive return of basis, which isn’t taxable; capital gain pro rata (as received) over time, which is taxable at applicable capital gains tax rates; and ordinary income from the interest payments, taxable as ordinary income.
Despite the ability to foreclose on the asset in the event of a default, there’s a possibility that the buyer may not make timely payments or may cause the value of the asset to decline and then simply walk away, leaving the seller with a diminished value (or valueless) asset on which to foreclose. This can be prohibitive to the would-be installment seller.
This concern has spurred installment sale strategies over the past several years. Numerous programs essentially lock up the sale proceeds by investment into a third-party trust, limited liability company, or other entity, or by using an assignment company. Each entity can, in different ways, invest the sale proceeds in a manner designed to produce reliable income over time; avoid constructive receipt on behalf of the seller, the step transaction doctrine, and other tax and legal prohibitions; and satisfy the business purpose rule.
The strategies outlined above attempt to take advantage of Section 453’s benefits while reducing the chance that the buyer will default or use the asset in a way that plummets its value, leaving the seller with no viable option in the event of foreclosure. Such structured installment uses a third party to receive and invest the sale proceeds to enable the buyer to comply with its obligations to the seller under the note in a way that the seller deems reliable.
However, the seller must do its homework before engaging in a structured installment sale. Because of this strategy’s increasing popularity as a 1031 alternative, or, in the case of a business sale, as a tax deferral strategy where a 1031 isn’t available, bad actors may play fast and loose with Section 453’s requirements.
Owners of vineyards, orchards, timber farms, fisheries, and a host of other agricultural lands can use Section 453A of the tax code, which affords taxpayers in such farming and agricultural industries to defer their ordinary income for decades. It also allows owners of the land on which these activities take place to sell their farmland, ranches, vineyards, and fisheries, and defer the payment of capital gains taxes (also for decades).
Unlike the main body of Section 453, Section 453A(b)(3) excludes, from application of the interest charge and pledge rules, any obligations arising from the disposition of certain property used or produced in the trade or business of farming as defined in Section 2032A(e)(4) or (5). The absence of these rules for farming and agricultural lands and businesses create probably the best opportunity for legal tax deferral with the least number of rules and regulations.
It’s important to distinguish vineyards and wineries from cannabis growers and dispensaries, however. Growers of grapes, hemp, and cannabis are included in Section 453A. Sellers of refined products such as wine, certain manufactured hemp products and edibles, oils, and the like wouldn’t be able to take advantage of Section 453A.
Where there’s a single entity that has both a growing operation and a refining and sale of the refined product operation, good lawyering may be able to bifurcate these into a portion of the business that’s qualified and the other that isn’t.
About Horizon Tax Advantage
Horizon Tax Advantage leverages the tax code to ensure you cost-effectively maximize your returns