1031 Exchange land, and do it just like you 1031 Exchange rental property, and I’ll show you how.
But be careful to satisfy the all of the Rules of the Section 1031 Exchange transaction.
Go here for a full explanation of what a regular Section 1031 Like Kind Exchange is all about.
I will go through each of the Rules and explain how to satisfy them for your 1031 Exchange land transaction.
BUSINESS OR INVESTMENT PROPERTY
The property that you sell is your Relinquished Property, and the property that you buy to replace it is called your Replacement Property.
Remember these two terms.
The Relinquished Property must be property that you have “held for productive use in a trade or business or for investment.”
You satisfy this rule if you have owned the land for more than a year, and you have decided that you want to sell it.
In order to defer the Capital Gains taxes on the sale of the property, you must acquire another “like kind” property to replace it.
The Replacement Property must be property “which is to be held either for productive use in a trade or business or for investment.”
That does not refer to what the property is being used for by the current owner.
The definition refers to what you will use the property for after you buy it.
It is critical that you understand this distinction, how you intend to use the property, it is part of the foundation of the 1031 Exchange process, and especially so if you 1031 Exchange land.
1031 EXCHANGE LAND: LIKE KIND PROPERTY
This will be an easy rule to satisfy if you are selling land and then buying land.
They obviously qualify as “like kind.”
But “like kind” does not mean that the property itself must be like each other in physical appearance.
The “like kind” refers to the definition of property “held for productive use in a trade or business or for investment.”
So, you don’t have to buy land, just because you sold land.
You can sell land, and then buy an apartment building, because it meets the definition in Section 1031 of like kind property.
BUSINESS OR INVESTMENT PROPERTY
There is an odd twist in the definition of the Relinquished Property and the definition of the Replacement Property.
If you look closely, you will see the distinction, and understanding it will help you understand the underlying concept of the Section 1031 Like Kind Exchange, and why you can 1031 Exchange land.
The 1031 Exchange Rules requires that the Relinquished Property be “property held for productive use in a trade or business or for investment.” That refers to what you are using the property for right now, at the time that you are doing the sale.
The Replacement Property, however, must be property “which is to be held either for productive use in a trade or business or for investment.” That refers to what you will use the property for after you buy it.
So, as you can see, you are entering into a commitment with the IRS that you will hold the Replacement Property either for investment, or for the productive use in a trade or business.
For how long?
Well, that depends on whether you believe me, or you believe all of the other so-called experts on the web.
Since 2017, I have been saying that you must hold this property for at least a year and a day in order to satisfy this requirement (and have been trashed in the real estate forums for saying so, not that I cared).
The reason that I have always said that you must hold the property for at least a year and a day is because that period of time would then qualify the taxation of the gain or profit as Long Term Capital Gains.
And Section 1031 was written to apply to Long Term Capital Gains, not Short Term Capital Gains.
On the other hand, although some have changed their position since 2017, most of the other content that you find on the internet will still tell you can you can sell the property whenever your circumstances indicate that it is a good idea, and they also say that you can refinance it at any time, and, in effect, get your Capital Gains out, and not pay any taxes since loan proceeds are not taxable.
I think both positions are incorrect.
So, you make your choice and you take your chances.
Just be aware, after the deal is done, you will fill out Form 8824 and tell the IRS exactly what you have done, including the dates.
And keep in mind that most people writing about Section 1031 have no idea that it is actually a law, passed by Congress, after extensive debate, and contains a report called “Legislative Intent” which explains the purpose and goal of the law. These individuals think that they are just telling you about some trick to save taxes that they read about.
REPLACEMENT PROPERTY PRICE
The price that you pay for the Replacement Property must be equal to, or greater than, the sales price of the Relinquished Property in order to qualify for a Total Tax Deferral. If it is less, you can still qualify for a Partially Tax Deferred Section 1031 Exchange.
Your Replacement Property can be more than one piece of property. See the 45-Day Rule below.
NET SALES PROCEEDS
When you sell your Relinquished Property, and you go to the Closing, the amount of money that you are entitled to receive after all of the costs are paid, is referred to as the Net Sales Proceeds.
But you are not entitled to receive those funds at Closing.
The rules of the 1031 Exchange require that all of your Net Sales Proceeds be used when you purchase your Replacement Property.
If you take out part of the Net Sales Proceeds when you 1031 Exchange land, that part will be taxable to you as what the IRS calls “boot.”
The rate at which you will be taxed will depend on how much you take, how much Depreciation you have claimed in the past, if any, and what Capital Gains Tax bracket you fall into.
You can explore this further at S1031Exchange.com.
This rule will be very simple for you to satisfy if you 1031 Exchange land.
It just says that you have to buy the Replacement Property in the same name in which you sold the Relinquished Property.
But some real estate investors get tripped up on this, because they use an LLC.
Either the Relinquished Property was held in the name of their LLC, and then they buy the Replacement Property with a different LLC, or they buy the Relinquished Property in their own name.
Don’t do that.
If you sold the property in your own name, you must buy the Replacement Property in your own name, or in the name of an LLC in which you are the sole member, called a Single Member Limited Liability Company (SMLLC).
If you sold the property in the name of an LLC, you must buy the Replacement Property in the name of that same LLC. Or, if the selling LLC was a SMLLC and you were the single member, then you could buy the Replacement Property in your own name.
But I always recommend buying real estate in the name of your LLC, never in your own name.
THE 45-DAY PERIOD
If you 1031 Exchange land, there are two timelines that are critical, and this is the first one.
The date on which you Close on the sale of your Relinquished Property is called the “Exchange Date.”
Within 45 days of this date, you must identify in writing the property that you intend to purchase as your Replacement Property.
There are three methods you can use to identify the property or properties that you will purchase.
- First, you can identify up to three properties without regard to the value of each, or the total value of all three.
- You can identify as many properties as you want, as long as the total value of all of the properties is not more than 200% of the value of the Relinquished Property.
- And the most complicated of the 1031 Exchange Rules, you can identify as many properties as you want, without regard to the “200%” limitation, as long as you end up closing on enough of the properties to represent 95% of the total value of all of them. This third option is seldom used because it is so difficult to understand and to follow.
You make the identification in writing, usually to your Qualified Intermediary.
THE 180-DAY PERIOD
The second of the two “1031 Exchange Timelines” is the 180-Day Rule.
This Rule says that within 180 days of the Exchange Date, you must Close on the purchase of your Replacement Property.
There are consequences for you if you do not Close on your Replacement Property within 180 days of the Exchange Date.
- The entity holding your Net Sales Proceeds will distribute those funds to you,
- You will not be permitted to engage in a Section 1031 Exchange, and
- You will pay Capital Gains and Depreciation Recapture Tax on the sale.
The IRS will not impose penalties or interest.
But there is no appeal of this situation. Miss the 180 day point, and the 1031 Exchange is off.
“Related Party” is not just someone related to you.
It is that, but the IRS has a particular list of persons related to you that are classified as a Related Party, for someone planning to 1031 Exchange land.
Related Party means your spouse, your brother, your sister, your child, your grandchild, your parent, or your grandparent.
One of the Rules of Section 1031 Exchange is that you will have certain conditions imposed on the transaction if you sell your Relinquished Property to, or buy your Replacement Property from, a person related to you, a Related Party.
And a Related Party also includes a corporation, partnership, Limited Liability Company, or similar business entity in which you own more than 50% of the interest.
This percentage includes your spouse’s ownership.
Related Parties are allowed to do a direct swap of properties, but each party must hold the acquired property for a period that is more than two years after the date of the last transfer.
Also, each Related Party must continue to file Form 8824 for two years following the year of the Exchange.
In addition to swapping properties, the Rule permits you to sell your Relinquished Property to a Related Party, but if you do so, the Related Party is required to hold the property for the two-year period described above. And if the Related Party does not, the transaction will be declared invalid under the 1031 Exchange Rules, and taxes, penalties, and interest will be imposed on both parties.
As for buying a Replacement Property from a Related Party, you can do so, but you will have the same two-year reporting requirement for Form 8824. And it will almost guarantee that the IRS will audit the transaction because this is where they find most of the abuse of the Section 1031 Exchange, family members trying to game the system. So, this is where they are looking.
1031 EXCHANGE LAND: QUALIFIED INTERMEDIARY
Of all the 1031 Exchange Rules, the most important is the one that says you cannot have actual receipt of, or constructive receipt of, or control over, the Net Sales Proceeds.
The Net Sales Proceeds are the funds you are entitled to receive at the Closing on the sale of your Relinquished Property.
Violate this one Rule, and the 1031 Exchange is over immediately.
To avoid touching the money, what you do is sign a document called an Assignment of Benefits of your Sales Contract for your Relinquished Property to an independent third party.
Usually this third party is what the IRS calls a Qualified Intermediary.
The name “Qualified Intermediary” does not mean that the individual or entity is “qualified” in any way to do anything, and they often are not qualified.
A Qualified Intermediary, generally referred to as a QI, is an entity that is not disqualified by the IRS from providing the service, being disqualified because of having had a family or business relationship with you during the past two years.
Think about that. It is the crux of the problem. The IRS decided to refer to anyone who has not been disqualified as being “qualified.”
That is not the definition of “qualified.”
So the only reason that the IRS refers to them as qualified (intermediary) is that they are not disqualified by the IRS’s definition of being disqualified.
It has nothing to do with their ability to do the job.
The QI is not licensed, or even registered, by the IRS, or any other federal, state, or local government regulatory agency.
Their activities are completely unregulated.
The IRS, in their Tax Gap series fact sheet, even warns the Taxpayers about them:
“Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligation to the taxpayer. These situation have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.”
This is the IRS telling you that if you turn over $400,00 from the sale of your Relinquished Property to your QI to be used in the purchase of your Replacement Property, and the money disappears, you not only lose out on the Replacement Property, but you’ve also lost your Relinquished Property, your money is gone, and you still owe the IRS the Capital Gains Tax on the profit from the sale.
You can read an example of disappearing Escrow Account funds here.
When you sell your Relinquished Property, you will have some Basis in it that you have not depreciated yet (unless you have held it for 27.5 years, which you probably have not).
What happens to the Depreciation that you have not claimed?
Well, believe it or not, you are permitted under the 1031 Exchange Rules to continue to claim depreciation on this amount even though you no longer own the property.
If you 1031 Exchange land, this will probably not apply to you, because land is not a depreciable asset, but this is still interesting information, and good for you to know.
There are two possible ways to continue claiming depreciation after a Section 1031 sale, and you must tell the IRS which method you want to use. The IRS calls it making an “Election.”
You can either continue with your current Depreciation Schedule and continue to claim whatever depreciation amount you have been claiming each year. Call the item “Old Basis” on your Depreciation Schedule.
You would now have a new item on your Depreciation Schedule for your Basis in the Replacement Property, and call it “New Basis.”
Or, you can combine the basis in the Relinquished Property, it is called Transferred Basis, with the basis in the new Replacement Property, and start a completely new depreciation schedule on that total amount.
But you must tell the IRS which one you are doing. You do that by checking the appropriate box on your Form 4562 that says, “Election Made Under Section 1.168(i)-6T(i)” on the next tax return that you file.
I have more complete explanations of this process on my other site, S1031Exchange.com.
Well, that about wraps up the rules, and now I have more stuff for you.
I touch on this same concept in more than one of my books, but the one with the most detailed information is “Real Estate Investing Vocabulary Of Terms.” If you would like to preview it, you can go here on this website to look at it first, use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then you should start with a Dictionary, and I have done one, in 3 separate Blog Posts here: Part 1, Part 2, and Part 3. And I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
And if you think you might like to read one of my books, but can’t decide which one, here are four that I recommend.
I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. But I am not your Attorney. I would be honored if I were, but I am not. Reading this Blog does not created an attorney-client relationship between us. Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.