Vacant land is a real estate asset that is eligible for a 1031 exchange transaction. However, 1031 exchanges can be tricky to execute, and a deal involving vacant land has a few extra pitfalls to watch out for.
Buying the vacant land to build on and sell for a larger price indicates you intend to sell, not invest. One of the core provisions of the IRS rules on 1031 exchanges is that the property must be held for investment or business use. Property that you acquire to resell (like a condominium development) that you acquire for the purpose of selling the units to buyers) doesn’t qualify. On the other hand, if you buy vacant land with the hope that the value of the land itself will increase, then you may be eligible to acquire or dispose of it using a 1031 exchange.
The tax deferral you can get using a 1031 exchange is an excellent way to leverage your investment capability by reinvesting the entire sales proceeds. Because of the significant nature of the tax advantage, the IRS, not surprisingly, safeguards the opportunity to ensure that it isn't misused. The “Like-kind” requirement is one such guardrail, although the IRS does allow the exchange of almost any investment property. For example, you can swap an apartment complex for a self-storage facility, a retail mall for an office building, or a restaurant for farmland.
The rules also require the exchange to be completed in a short time—no more than 180 days from the sale of the original asset to the completion of the replacement purchase. That’s one reason that a build-to-suit exchange is difficult to accomplish. Suppose the investor wants to exchange improved property for vacant land, but the value depends on the completion of improvements. In that case, the improvements must be finished within that 180-day limit. If the upgrades are unfinished, resulting in the replacement property being valued at less than the proceeds from the relinquished asset, the difference is taxable boot.
That’s because one of the requirements for a 1031 exchange is that the replacement property has a value at least equal to the value of the relinquished asset. Any debt attached to the relinquished property must also be matched by equal debt for the replacement property. If the investor ends up with cash, that’s taxable income.
To successfully execute a 1031 exchange for the purpose of buying land for development, you will need to employ an Exchange Accommodation Titleholder (EAT). This role is more significant than the Exchange Accommodator (also called a Qualified Intermediary), which is an integral part of every 1031 exchange. The EAT maintains an account for the proceeds of the relinquished asset sale until they pay to complete the acquisition of the replacement property. They also receive formal notification of replacement property under consideration and administer the documentation necessary for the exchange.
For a build-to-suit exchange, the EAT acquires the title to the targeted vacant land, holding it until the improvements are completed, and the original investor can then proceed with the exchange.