Owning land is a great investment, with high potential for appreciation and generally good profit margins. However, investors must take into account capital gains when selling land. In particular, you must consider how the realized profits result in tax liability. While taxes are not avoidable in most cases, there are strategies you can use to defer. Below, Realized 1031 shares how to avoid capital gains when selling land.
As an investor, you want capital gains, as this is the profit you make from selling a real estate asset, such as land. What many want to avoid is the substantial taxes associated with capital gains, given that the value is still considered a type of income.
To calculate capital gains taxes, you must first determine the actual realized profit. This number is the leftover amount after deducting the adjusted cost basis of the land from the final sales price. Then, you multiply the difference by your capital gains tax rates based on your current tax bracket. Since 20% is the highest rate, a $200,000 capital gain would result in $40,000 tax liability — a substantial amount.
Here are a few methods that you can employ to manage capital gains taxes after your land is sold.
A 1031 exchange is a type of transaction where you swap two like-kind properties. In this context, like-kind means both assets must have been held for business or investment use. Land qualifies, especially land that is being used for agricultural business or land that is going to be developed for commercial use.
When the exchange is done following IRS guidelines, all capital gains taxes will be deferred until a triggering event occurs. This benefit allows you to keep more of your capital working for you. Keep in mind, though, that 1031 exchanges are complex undertakings. Any incorrect step or missed deadline could result in immediate tax liability.
Similar to the 1031 exchange, the 721 exchange allows you to defer capital gains taxes until a triggering event. This time, you contribute your property to an umbrella partnership real estate investment trust (UPREIT). In exchange, you receive operating partnership (OP) units, which are the economic equivalent of REIT shares.
Compared to 1031 exchanges, UPREITs offer additional benefits like truly passive income, access to diversified assets, and professional management. However, converting OP units to REIT shares for selling or trading will result in a taxable event.
Compared to IRS Revenue Code exchanges, an installment sale will still result in capital gains taxes each year. That’s because, in this strategy, you sell your land and receive the proceeds in installments annually. You’re still receiving income, which means you’ll still owe taxes. Thankfully, you’re able to spread out the tax liability over a few years instead of paying one lump sum.
One major benefit of installment sales is that you receive liquid cash on a pre-determined frequency. Income is more predictable, and most of your cash isn’t trapped in assets with holding periods.
A charitable remainder trust (CRT) allows you to transfer your land into a trust before selling it, thereby avoiding immediate capital gains tax on the sale. The trust sells the land and reinvests the proceeds, then pays you (or another beneficiary) a set income for a fixed term or for life. Only during these payments are capital gains taxes recognized, making CRTs work similarly to installment sales. At the end of the trust term, the remaining assets go to a designated charity.
CRTs can offer an upfront charitable tax deduction, a steady income, and a significant tax deferral. This strategy works best for highly appreciated land when you want both financial benefits and a meaningful philanthropic legacy.
For estate planning purposes, gifting land is also a viable strategy. Transferring the asset to a trust or a beneficiary won’t trigger immediate tax liability. Instead, the basis and appreciation carry over. Only when the receiver sells the property will capital gains taxes come into play. Even then, the beneficiary can employ the aforementioned strategies to defer tax liability.
Keep in mind, though, that gift taxes may apply. Land can have a substantial value, and the lifetime exception for gifts is $13.99 million. Beyond this amount, the giver will be liable to pay gift taxes.
If you hold the land until your passing, the asset receives a step-up in basis. The new cost basis is the land’s fair market value upon your death. As such, this is the only strategy that eliminates capital gains taxes, especially if your heirs decide to sell the land before any significant appreciation occurs.
There are many avenues you can take to manage capital gains taxes. The route you’ll take ultimately depends on your investment goals, risk tolerance, and estate planning needs. For example, those nearing retirement may want the passive nature of UPREITs or CRTs. If you still want direct control of your assets, 1031 exchanges are the way to go. Regardless of the options, always consult with tax professionals or financial advisors to help you create a tailored plan that aligns with your goals.
Avoiding capital gains taxes after selling land is a common objective for many investors. Thankfully, tax-deferral strategies are available, such as 721 and 1031 exchanges, installment sales, and CRTs. Proactive planning and in-depth research with the help of a professional are still the best practices to help you figure out which option works best, even before selling your land.
Sources:
https://www.investopedia.com/terms/c/charitableremaindertrust.asp
https://www.investopedia.com/terms/u/upreit.asp#
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/