The Tax Free Way to Turn Land into a Lakehouse

For my first tax savings trip, I’ll put this 100-acre tract of Texas raw land into my magician's hat. Also going into that hat is the 20% capital gains tax on the sale of the land. Next, I’ll wave my magic wand, say the magic words, “1031 exchange”, and presto—out comes a lakefront home in Florida that I paid zero capital gains on. In my case, doing a 1031 exchange saved me from paying tens of thousands in taxes when I sold my ranch is Texas for double what I paid for it. Until a few years ago, I had never heard of a 1031 exchange. Remarkably, even some of the most savvy real estate investors in my network do not know a 1031 exchange can be used to exchange raw land for future commercial and residential real estate investments (and vice versa). This article will provide an overview of what a 1031 exchange is and how it is a powerful wealth-building tool.

1031 Exchange Basics

A 1031 exchange, also known as a like-kind exchange, is a tax strategy that allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar property. While 1031 exchanges are commonly used for real estate properties such as apartments, office buildings, and retail centers, they can also be used for raw land.

Step 1: Identify a Qualified Intermediary

To 1031 raw land, the first step is to identify a qualified intermediary (QI) who will hold the funds from the sale of the relinquished property and assist in the acquisition of the replacement property. The QI will work with the investor to ensure that the transaction meets all of the requirements of the 1031 exchange, including the 45-day identification period and the 180-day exchange period. You must use a QI before the sale of your first property closes. My advice is to find a QI once your property is under contract and let your realtor and settlement attorney know you are doing a 1031 exchange.

Step 2: Find Your Next Property

After selling your first property, you have 45 days to identify a replacement property of similar kind (i.e., investment) to defer capital gains taxes. The replacement property's purpose must match the relinquished property. Once identified, you have 180 days to complete the purchase. To fully defer taxes, reinvest the entire sale proceeds into the new property. For example, if you sell a $250K tract of land, your next property must be $250k or more to defer all capital gains. Staying with this example, let’s say you find a second property but it’s only $200K. You can still conduct a 1031 exchange; you will just pay capital gains taxes on the difference between the sale price of your first property and your second property. In this case, you would pay capital gains on $50K.

Step 3: Use Your Property Smartly

One thing to keep in mind when 1031 exchanging raw land is that your next property must be held for investment purposes, not for personal use. This does not mean you can never use the property for personal use. To prevent the IRS from challenging whether a property, like a vacation rental, qualifies for a 1031 exchange, it must be rented out for at least 14 nights each year for a two-year period. Additionally, your personal use of a vacation rental property must not exceed 14 nights per year or 10% of the number of days in a one-year period that the property is rented out. The time you spend at the property to carry out repairs, annual maintenance, etc., is not counted towards the 14-day limit. In short, if you 1031 exchange raw land to a 'beach house' you can still use the beach house, you simply have to be mindful of the personal use rules.

Final Thoughts

In conclusion, a 1031 exchange is a highly effective tax strategy that allows real estate investors to defer capital gains taxes by reinvesting the proceeds from the sale of an investment property into a similar property. This can be applied to various types of properties, including raw land. By following the steps of identifying a qualified intermediary, finding a suitable replacement property, and using the new property for investment purposes, investors can build wealth more efficiently while minimizing their tax liabilities. Take advantage of this powerful tool to maximize your real estate investment returns.

Please note that I am not a tax professional. The information provided is for educational purposes only and should not be considered as tax advice. It is always recommended to consult with a qualified tax professional for personalized guidance on your specific situation and tax implications. Please reach out with any questions or feedback at [email protected].