Managing real estate for retirement purposes
November 23, 2016
Many farmers, ranchers and others involved in agriculture are self-employed. Their retirement account grows by photosynthesis. As farmers and ranchers approach retirement age, they're faced with some pretty tough decisions about how to go about retiring.
Danielle Kurtzleben, US News & World Report staff writer wrote, "Everyone knows American workers are aging, but farmers are longer in the tooth than workers in almost any other occupation. According to the Labor Department, the median age for farmers and ranchers is 55.9 years…" During the last three decades, "…the average age of U.S. farmers has grown by nearly eight years, from 50.5 years to 58.3 years."
The traditional lifestyles of self-employed agriculturalists often neglect planning for retirement. According to FORBES article "The Retirement Crisis" by Laura Shin, published in April 2015, "The self-employed can establish retirement plans for themselves, such as the solo 401(k), the simplified employee pension plan, or SEP, IRA, and the SIMPLE-IRA. But in 2011, this group had the lowest participation rates — 13 percent, compared to 83 percent of workers in public administration."
How can these aging owner/operators parlay their real estate into a secure retirement?
Estate planning walks hand-in-hand with real estate liquidation, and Julie Pedersen, Associate Broker/Owner and founding member of Arnold Realty, Inc. (http://www.eranches.com/) at Newcastle, Wyoming says, "Decide what your goals are and then assemble a good team of professionals to assist in the process. Your attorney, accountant and investment manager need to work in conjunction to create the plan that best fits your needs, while minimizing estate taxes. When selling property, you need to consult with your accountant right up front, when you list the property for sale," she adds. "Don't wait until you have a signed purchase contract to figure out how much capital gains tax you will have to pay. Discuss the options with your accountant and convey that information to your real estate broker, so everyone is on the same page from the beginning.
"For instance, if you plan to purchase other property, you may be able to delay capital gains by using a 1031 Tax Deferred Exchange," Julie explains. "Or if your principal residence is on the land you are selling you may be able to exempt the residence portion of the sale up to a certain amount and take those funds tax free. If your sale includes machinery or livestock, that adds yet another component. Planning ahead is key to minimizing taxes."
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Part of that planning entails choosing from a variety of sale possibilities, one of which is a lease with an option to purchase — also known as a “lease option.” It may appeal to sellers, who can benefit from market appreciation if the tenant does not exercise his option to purchase.
Donald J. Valachi, CCIM, CPA, associate clinical professor of real estate at the University of Southern California says, "The important income tax question in lease-option transactions is whether the tenant is leasing the property or, as an economic reality, an installment sale has occurred prior to the tenant exercising the purchase option. No single factor determines whether or not a lease option is, in economic reality, a sale."
Gerald J. Robinson, a noted tax authority, said in Federal Income Taxation of Real Estate, "A determination involves studying many factors, including the terms of the lease, the surrounding economic circumstances, and the intent of the parties . . . A collection of telltale signs leads to the conclusion that exercise of the option was virtually certain from the outset, so that treating the entire transaction as a sale is warranted."
Donald Valachi explains, "If a lease option is treated as a sale, there are two important tax implications: 1.The timing of the transfer of ownership of the property is changed. With a “true” lease option, ownership transfers when the option is exercised. If the transaction is treated as a sale, then ownership transfers when the parties execute the original agreement. 2. The nature of the option payment and the rent payments during the lease period are changed. Because the tax treatment of a purchase transaction is so different from a lease transaction, it is important to understand the factors that may lead the Internal Revenue Service (IRS) to characterize a lease-option transaction as a sale."
Michael P. Sampson says in Tax Guide for Residential Real Estate: “…if you can demonstrate that the reason for the lease option is the impossibility of a cash sale because of economic conditions, the form of the transaction as a lease option will probably stand. This would be the case, for instance, where your purpose is to tie down the property during a tight money market, with the expectation that within the option period you can get institutional financing.”
"Although the lease option is a valuable strategy in many situations, it should be used with great care," warns Valachi. "There is always a threat that the IRS may view the lease-option transaction as a sale and the lease as merely a financing device. Rents that are significantly above fair market rents, when combined with a 'bargain' option price, indicate that the transaction is likely to be characterized as a sale and that the rental payments are, in fact, installment payments on the purchase price. Thus, both the rental payments and the option price should be set by the parties with reference to going market values and rents for similar properties. And the parties should be prepared to justify their estimates of rent and purchase price if the transaction is later challenged by the IRS. Rental value and property value are best established through independent appraisal by experts," Valachi advises.
Contract for deed
Multiplying the confusion is yet another sale option – "contract for deed." It can allow the seller to get more down payment from the buyer and the seller can also collect interest payments, often more than could be collected in rent. However, the 1031 tax-deferred exchange cannot be used on a property sold by contract for deed when the buyer pays off the debt balance.
Crystal Myslajek, Community Affairs Intern with Federal Reserve Bank of Minneapolis wrote in January 2009, "While contracts for deed offer some advantages over a traditional mortgage, such as speed and simplicity, they can entail distinct risks for buyers and sellers."
"A contract for deed, also known as a 'bond for deed,' 'land contract,' or 'installment land contract,' is a transaction in which the seller finances the sale of his or her own property," Myslajek explains. "In a contract for deed sale, the buyer agrees to pay the purchase price of the property in monthly installments. The buyer immediately takes possession of the property, often paying little or nothing down, while the seller retains the legal title to the property until the contract is fulfilled. The buyer has the right of occupancy and, in states like Minnesota, the right to claim a homestead property tax exemption. The buyer finances the purchase with assistance from the seller, who retains a security in the property.
"In a typical contract for deed, there are no origination fees, formal applications, or high closing and settlement costs. Another important feature of a contract for deed is that seizure of the property in the event of a default is generally faster and less expensive than seizure in the case of a traditional mortgage," Mysaljek says. "If the buyer defaults on payments in a typical contract for deed, the seller may cancel the contract, resume possession of the property, and keep previous installments paid by the buyer as liquidated damages. Under these circumstances, the seller can reclaim the property without a foreclosure sale or judicial action. However, laws governing the contract-cancellation process differ from jurisdiction to jurisdiction and the outcome may vary within any one state, depending on the contract terms and the facts of the specific case."
Then there's the popular 1031 Exchange. The large firm of Chas. H. Middleton & Son dealing in farm and ranch real estate since 1920 across Texas, New Mexico, Oklahoma, Kansas and Colorado reports, ". . . over 50 percent of the transactions we handle involve a 1031 either on the side of the seller, the buyer, or both." Middleton calls the process "fairly simple" but highlights specific time constraints that must be met to qualify, saying "The 45/180 day rule as it has become known sets the limits involved."
Sherrie Nutter, of the Rapid City, South Dakota office of Land Brokers, Inc. explains, "The timeline for doing a 1031 Exchange is probably one of the most important factors to consider, so thoughtful preparation is key. First, you must identify your replacement real estate within 45 days; then close your purchase of it within180 days after closing your original sale. Considering the magnitude of what you potentially may be selling and purchasing, this timeline is really very short."
"Before you begin your sales process it's imperative to know what replacement real estate you're looking for, and in what area," Nutter recommends. "Also remember that your replacement real estate must be a like property (i.e. income-producing) and of equal or greater value than what you are selling in order to defer 100 percent of your taxable capital gain."
Sherrie Nutter says that Joe Nutter, broker and head of the North Platte, Nebraska office "works with an extensive amount of 1031s, as his clients are typically selling and buying large ranches. He is where our expertise comes from and is the reason I am where I am."
The devil is in the details of 1031 transactions, as Middleton & Son explain, "It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable. One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete."
Sherrie Nutter recommends, "Knowing what professional help you need will ensure greater success. You can think of it as your '1031 Team' – your real estate broker, your accountant, potentially an attorney (depending on the complexity), the title company and an exchange company that will serve as the intermediary or facilitator of your funds until everything is complete and ensure that the monies are handled appropriately to meet all the IRS guidelines. We are fortunate that our Rapid City title companies have affiliate exchange companies that can serve as intermediaries, making it possible for us to build a big part of your 1031 Team under one roof."
The rules underline the necessity for that, as Middleton warns, "You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator."
J.D. Hewitt, owener of Hewitt Land Company in South Dakota said, "In addition to following the proper procedure, there are several related factors to consider in contemplating an exchange such as investment goals, timing/duration of investment, type of property (income producing or property held for sale), suitability and use, management, rate of return vs. risk exposure, level of debt to be included and debt serviceability. These are some of the factors a competent real estate professional can help you work through. Keep in mind that not every real estate investment is right for every individual."
It is a complicated maze, but any self-employed farmer or rancher can manage it successfully by surrounding themselves with some knowledgeable, trustworthy professionals from their communities.