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Using the 1031 Tax Exchange to Buy Hunting Land
The 1031 tax exchange is a much-used method for turning a little into a lot. Understanding how it works is critical to making the best use of this important investment tool. Many deer hunters have used this tool to accumulate their dream property.
The 1031 tax exchange is one of the key factors keeping a fire lit under the land boom. It takes its name from the section of the IRS code in which you will find it. Concisely, the 1031 tax exchange allows you to sell one piece of real estate and replace it with another one while deferring capital gains tax and recaptured depreciation to a later date when you choose to cash out of your real estate holdings - if ever.
You want to own your dream hunting land, but you haven't been able to find it. At the same time, you keep seeing the price of land going up. You fear that the price will grow too high before you find the dream piece and you will no longer be able to afford it. This is a common problem, but thankfully, there is a solution.
The best strategy is to buy a good property in a good neighborhood. Maybe it isn't your dream piece, but it is good nonetheless. You can improve it and pour your heart into it. When your dream piece does come up on the market, you will have a high quality piece to sell and then you can exchange the capital gain (using the 1031 tax exchange) into the dream piece. Ideally, you can get an option on the farm you wish to buy, giving you some time to sell, or possibly you can get the seller to sign a contract permitting you to sell yours first.
Many deer hunters also use the 1031 exchange to trade up for larger pieces when they have accumulated good equity in their initial piece of land. They then use this equity as the basis for a large down payment in their bigger dream farm. Of course, not having to pay capital gains taxes makes the equity go a lot farther.
Overall, the 1031 is a great tool for deer hunters looking to make the most of their money. I have used it three times during the past three years to help accumulate more land near my home. In the process, I figure it has saved me nearly $90,000 in taxes! I then put that $90,000 to work buying land rather than paying taxes.
There is a gray area related to the 1031 exchange that I have encountered a few times. A number of hunting land investors I know are under the impression that the velocity of their transactions will some day get them in trouble. They fear that because they are buying and selling often, in the event of an audit their 1031 activities will be disqualified.
Different accountants when asked about using the 1031 to buy hunting land have slightly different takes. Here is a portion of the actual language in section 1031 of the actual IRS code:
"...no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment."
The problem lies in the interpretation of the word "investment". Some think that investment carries with it an implied holding period. That may or may not be the case. My accountant doesn't think so. But to be on the safe side, if you are able to hold the land for at least one year before "trading up" you won't have any worries.
An even bigger issue revolves around the actual taxes triggered when you finally cash out. This confusion stems from the fact that the 1031 is a tax deferral tool. The word defer implies that you will pay them later. When you cash out you will trigger taxes all the way back to the first sale. Some believe that transactions involving properties held for less than a year will be taxed at the short-term rate even though you used the 1031 to move the proceeds into another parcel.
Again, according to a tax accountant, these fears are unfounded. According to him, as long as you hold the final property for at least a year before selling it, you only pay long-term capital gains back to your original basis - the original cost you paid for the first property.
Other accountants interpret this differently, as noted. They suggest that you will actually be triggering short-term capital gains on the properties you held for less than a year. One accountant assures that this is not true. But to be safe, be sure that you come to a complete understanding of this issue with your own tax accountant before you trade up with property that you have held for less than a year.
How the 1031 Tax Exchange Works
You must make a like-kind exchange. Like-kind has a broad interpretation. For example, certain realtors specialize in helping customers from California park the proceeds from the sales of their franchise properties in farmland until they can find a different use for the money.
Some 1031 tax exchange can be tame by comparison. Replacing hunting land with hunting land is very simple. However, any kind of real property is exchangeable with any other kind of real property. However, you can't exchange the sale of ownership in a subchapter S land corporation with personal property or other shares in a subchapter S. Stock in a limited partnership is not real property.
The 1031 exchange works as long as you never have actual or constructive receipt of the funds from the sale of the relinquished property before those funds are used to purchase the replacement property. In other words, an intermediary has to handle both closings for you and you can't have any kind of access to the money - even to borrow against it - until the entire process is completed.