As a buyer of rural land, you don’t need to become an expert on the 1031 exchange. But it’s worth your while to become familiar enough with the subject to know when it might be a viable option for facilitating your purchase. 1031 exchange rules allow its use with nearly any real estate asset, with the exception of a primary residence or second home.
A property owner may be highly motivated to sell but fearful of being heavily taxed on capital gains represented by a significant increase in value since the land was purchased. Sometimes, the tax penalty for selling a property can exceed the amount of profit on the sale.
But Section 1031 of the IRS tax code provides a perfectly legal way for him to defer paying those onerous capital gains taxes. All that’s required is that he purchases another qualifying real estate asset of similar value, using the profit from the land being sold. And both the purchase price and the new loan amount must be the same or higher on the replacement property.
There are essentially three methods of 1031 tax exchange: delayed, three-party, and simultaneous with a qualified intermediary.
In a delayed exchange, a facilitator holds the cash after you sell your property and uses it to buy the other real estate on your behalf. The IRS then views the two transactions as a swap. It’s important to note that the actual conveyance of the relinquished property must occur before the seller acquires its replacement.
A three-party exchange involves using an “accommodating party” who takes the title as a way of helping to facilitate the transaction for the taxpayer. Most legal and tax advisors strongly advise their clients not to use this method. It provides very little documentation to support the fact that an exchange has taken place other than the recording of the deeds, and it exposes the facilitators to any issues that may impact the 1031 exchange properties.
According to the 1991 Treasury Regulations, the only “safe harbor” for a simultaneous exchange is using the services of a qualified intermediary (QI) – sometimes called an exchange accommodator or facilitator. That individual provides written instructions to the closing officers and prepares the exchange agreement and other necessary documents, so the taxpayer is insulated from any “constructive receipt” issues. The QI format can be easily converted to a delayed exchange, which eliminates the time pressure of trying to close the entire transaction simultaneously.
As an investor, there are a number of reasons you may consider a 1031 exchange, including:
●Buyers looking at a property that has better return prospects, or buyers may want to diversify assets
●Buyers may want to look into a managed property rather than one to manage themselves
●Buyers may wish to consolidate several properties into one or divide a single property into several assets
●Buyers may want to avoid depreciation recapture
The tax advantage provided by a 1031 exchange is a wonderful opportunity for investors purchasing rural land. The rule’s complexities allow for a great deal of flexibility, but at the same time, they make it prudent for you to obtain competent professional assistance at nearly every step of the process.