Completing a 1031 exchange can be a complicated journey. There are many moving parts to the exchange process, as well as important deadlines that can’t be missed.
Investors who want to complete 1031 exchanges in order to defer capital gains taxes on their relinquished properties should fully understand exchange rules and special stipulations prior to undertaking their exchanges. In this article we’ll discuss whether investors can use raw land as their replacement asset to compete 1031 exchanges.
In order to complete a successful 1031 exchange, investors must replace a relinquished asset with a property that’s like-kind in nature and usage. The Tax Cuts and Jobs Act of 2017 redefined what qualifies as a like-kind exchange.
Prior to this legislation, investors were permitted a wide range of personal and intangible property, including machinery, equipment, automobiles, collectibles, and intellectual property, to complete exchanges so long as these assets were used in business or trade. Starting Jan. 1, 2018, however, the exchange process is only applicable to real property.
Real estate doesn’t have to be in the same asset class or have the same perceived quality in order to qualify as a replacement asset in an exchange. The Internal Revenue Service views real property as generally like-kind to other real property. Using that logic:
The caveat among these various property types is that the replacement property must have a purchase price equal to or greater than the relinquished asset. You also must swap an equal or greater amount of debt. You can’t use an exchange to improve your financial position or reduce leverage in investment real estate.
The IRS has a pretty broad definition of like-kind. The term refers more to the nature of an asset and its use rather than type, quality, or grade. The key is that the asset or property is held as an investment.
Using this reasoning, investors can exchange real property for unimproved property. The fact that any parcel of real estate is either improved or unimproved is immaterial. Raw land that’s held by an investor for future use or future realization of appreciation is considered held for investment rather than for sale.
According to the American Bar Association, vacant or raw land is not available for rent, so it’s considered an investment that’s held for a potential increase in value. This makes raw land a suitable replacement asset for any number of relinquished exchange properties.
Investors have a lot of rules they must adhere to when completing 1031 exchanges. Planning and execution are crucial to ensure successful exchanges.
Real estate owners who are considering exchanging investment properties for raw land should consult with taxation professionals and experienced exchange accommodators prior to beginning the exchange process to help them potentially avoid making any mistakes that could derail and invalidate their exchanges.