Published date:
October 31, 2024Last updated date:
October 31, 2024By Kelly Johnston
By Kelly Johnston, Broker Associate, Keller Williams Land
The 1031 Tax Exchange (so named for section 1031 of the IRS tax code), is a potentially profitable tax exemption for landowners – and one you may want to consider if you’re looking to sell and buy a land investment at the same time.
Also known as a “like-kind” exchange, the 1031 Tax Exchange allows qualifying landowners to defer capital gains taxes on investment property so long as they’re purchasing another property of equal or greater value within a set timeframe. Learn about the tax and wealth transfer benefits of a 1031 Exchange below, as well as possible downsides to this popular real estate tax strategy.
A 1031 Tax Exchange is a tax exemption offered to real estate owners who intend to sell an investment property and replace it with another one. Under the rule, investors can defer the payment of capital gains taxes on the sale of the original property so long as their new purchase is considered a like-kind exchange.
The IRS defines a like-kind property as one “of the same nature, character, or class,” of another owned property, regardless of quality, location, type, or grade. Notably, a like-kind exchange does not need to be an exact match in property value. Any cash earned above the like-kind threshold is taxed normally, with the option to still defer taxes on qualifying gains.
There are two main advantages of a 1031 Tax Exchange for land investors.
With a 1031 Tax Exchange, sellers get more cash in their pocket to invest in their next land purchase. And because of the broad scope covered in the IRS’s definition of like-kind property, landowners are not limited by location or property type when transferring these gains.
The 1031 Exchange Rule allows for the complete elimination of deferred capital gains if the original investor dies and the property is passed to one or more beneficiaries. This is known as a “step-up in basis.”
Likewise, a 1031 Exchange allows landowners to defer capital tax gains in perpetuity so long as they maintain ownership of the new property. Those who want to sell can simply use a 1031 Tax Exchange again by purchasing another like-kind property.
Land should be listed and sold using standard practices, with the only caveat (aside from needing to meet 1031 Exchange rules for qualifying properties) being that proceeds from the sale must be held in escrow by a qualified intermediary (QI). Sellers may only use these proceeds to purchase their like-kind exchange property. Any gains above the escrowed amount will be taxed as normal.
Land sellers have 45 days to find a replacement property and 180 days from that to complete the purchase. If this timeline is not met, the landowner will be disqualified from making a 1031 Exchange.
Aside from having to meet the designated timeline, real estate investors must also pay a 1031 Exchange fee to their QI – usually around $1,200 for a standard one-sell, one-buy exchange.
We’ve already discussed how a “step-up in basis” can eliminate capital gains taxes for any beneficiaries who inherit a property held under a 1031 Exchange. But as it turns out, that isn’t the only way a 1031 Tax Exchange supports wealth building and transfers.
Other wealth benefits of 1031 exchanges include:
If one of your goals as a land investor is to build generational wealth, a 1031 Tax Exchange can be a great way to do it, especially when used alongside certain specialized trusts such as Delaware Statutory Trusts (DSTs).
While there are limited instances where a 1031 Tax Exchange may apply to a principal property, this capital gains deferment technique is typically only applicable to investment properties.
This includes (with certain qualifying factors):
The distinguishing factors that apply to 1031 qualifying properties include that they must be real property, held for investment or business use, and like-kind eligible.
There are a lot of advantages to a 1031 Exchange. There are also some important disadvantages you’ll want to know about before going all-in.
A 1031 Exchange can be an excellent opportunity to increase your land investment potential and/or establish more wealth for you and your family. If you’re interested, we encourage you to talk to a financial planner to get more information and make sure you meet all the necessary qualifications.
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