Understanding Section 1031 Tax Exchanges While Purchasing Land
Raw land can make a great long-term investment. Raw land, depending on its location, can be affordable to purchase and maintain. It can also provide passive income and can be very easy to obtain.
A 1031 Exchange can be used to defer capital gains and use the proceeds to invest in new land. Any type of land, regardless of its development, is eligible for a 1031 exchange.
A 1031 exchange must be set up prior to selling land. Federal and state taxes will apply on the difference in the raw land cost and the sale price. These taxes can range from 20-30% to 40% in some states, such as California.
Qualifying Like-Kind Property
These requirements are required for a 1031 exchange when buying land.
The replacement and relinquished properties are being kept for investment or business purposes. These are the reasons that the IRS will determine qualified intent for a 1031 exchange. A tax-deferred exchange is not available for properties held for personal gain.
Relinquished or replacement properties must be similar in nature. The IRS defines "like-kind property" as properties that are the same type or character of the relinquished or replacement properties, regardless of their quality or grade. The above definition of a 1031 exchange and the property that qualifies is a common misconception. People mistakenly believe that "like-kind" refers to exchanging an apartment for another.
IRC Section 1031 doesn't limit like-kind property only to certain types of real estate. All real property is similar to other real estate. If you are looking to invest or start a business, you can exchange a commercial building for land.
These are some examples of qualified properties:
Multifamily residential, commercial, and industrial multi-family rental properties
Raw land, farmland or better real estate
Royalties on oil, gas, or mineral products
Perpetual water rights, dependent on state law
Stock may be held in a reservoir, mutual ditch or irrigation company
Mitigation credits to restore wetlands in exchange for other mitigation credits
Regulations For Personal Use
You can purchase land but you cannot use it as your primary residence.
There are strict rules that govern which properties can be eligible for tax-deferred exchanges and how they may be used. For example, a taxpayer may purchase multi-family residential properties as an investment, but it cannot use the property more than 10% during 12 months. It must also be rented for at least 14 days per year.
A tax-deferred exchange allows you to buy undeveloped land as long as it is qualified like-kind property and can be used for trade, business or investment. If you follow the rules and plan carefully, you can defer taxes when you purchase land through a 1031 exchange.
