1031 Exchange Into Raw Land: Holding Intent, Carrying Costs and the Dealer Line

Land qualifies when you hold it for investment, and the regulation says so directly

Section 1031(a) covers real property held for productive use in a business or for investment, and excludes real property held primarily for sale. Reg. section 1.1031(a)-1(b) adds that whether real estate is improved or unimproved goes only to grade or quality, and that unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment.

So an apartment building can be exchanged for a pasture, a desert parcel or an infill lot. The question is your purpose, and in Malat v. Riddell, 383 U.S. 569 (1966), the Supreme Court held that 'primarily' means 'of first importance' or 'principally'. Land bought mainly to resell is excluded even if you also hope to hold it a while.

Write your purpose down when you buy: appreciation, a future rental project you will own, a family holding. Board minutes, a memo to your CPA and the absence of listing activity are the evidence if the question is ever asked.

The dealer line is drawn by what you do with the land after you buy it

In Bramblett v. Commissioner, 960 F.2d 526 (5th Cir. 1992), the court listed seven factors, from the purpose and length of ownership to subdividing, advertising, a sales office and the time spent on sales, and said the frequency and substantiality of sales is the most important. A partnership that made five sales in three years was held to be an investor, not a dealer.

The same case shows a structure owners use when development is the goal. The partnership sold its land to a separate corporation owned by the same people, which developed and sold lots, and the court refused to treat the corporation's dealer activity as the partnership's. Planning like that needs counsel before you buy, not after, and the raw land and lots sale page covers subdividing and the section 1237 safe harbor.

Rezoning applications, platting, road building and marketing are each evidence of development. Holding land while its value rises with the market is the investor's posture; manufacturing that rise yourself is the dealer's.

Exchanging a depreciated building into land alone can trigger recapture with no cash received

When you sell a building in an exchange, section 1250(d)(4) limits ordinary-income recapture to the greater of the gain you recognize or the amount by which the recapture exceeds the value of section 1250 property you acquire. Land is not section 1250 property, so depreciation above straight-line on what you sold, such as bonus on land improvements, becomes taxable when the replacement is only land.

Section 1245(b)(4) works the same way for equipment and cost-segregated components: recapture is limited to gain recognized plus the value of non-section-1245 property acquired, and land is non-section-1245 property. Hypothetical: a rental with $200,000 of cost-segregation depreciation exchanged entirely into land can produce up to $200,000 of ordinary income with no cash taken out; run your own numbers with your CPA.

Straight-line depreciation on a post-1986 building is not additional depreciation, so a plain rental house or apartment exchanged into land usually has nothing to recapture. The trap is for owners who used bonus depreciation or a cost segregation study, and the fix is to buy some improved property with the land.

No rent and no depreciation, so taxes and interest have to be carried

Land does not depreciate, so the deductions that sheltered your rental income stop. Property taxes on land held for investment are paid in a section 212 activity, which section 164(b)(6) excludes from the state and local tax cap, and interest on a loan to buy it is investment interest that section 163(d) limits to your net investment income, with any excess carried forward.

If those deductions would be wasted, Reg. section 1.266-1 lets you elect to add annual taxes, mortgage interest and other carrying charges on unimproved and unproductive real property to basis instead. The election for those items is made year by year, so you can deduct in a year you have investment income and capitalize in a year you do not.

Hypothetical: $1,000,000 of land financed with a $500,000 loan at 7% carries about $35,000 of interest plus property taxes each year with no income against it. Budget that from other cash flow, because spending exchange funds on carrying costs is not possible once the exchange closes. Run your own numbers with your CPA.

Entitlement risk and the improvement you plan later

If you intend to build a rental on the land later, the building is not part of this exchange. Reg. section 1.1031(k)-1(e)(4) says production occurring after you receive the replacement property is not like-kind property, and Rev. Proc. 2004-51 bars using an accommodation titleholder to build on land you owned within the prior 180 days.

To use exchange money for construction, the improvements have to be built while an exchange accommodation titleholder holds the land and be in place by day 180; the new construction and building on land you own pages cover the mechanics. Price the land on its current zoning: approvals you hope for are a risk, not a value, and pursuing them yourself is a dealer factor.

Before day 45: diligence on land you cannot judge by its rent

Land has no rent roll, so the documents are physical and legal: title commitment, survey, legal access, current zoning and permitted uses, utility availability, flood status and any agricultural or open-space tax status that could be recaptured on a change of use. Under the federal all-appropriate-inquiries rule a Phase I environmental assessment must be done within one year before acquisition, with key parts within 180 days.

Because land pays nothing, many buyers pair it with income property. A split into land and a traditional DST interest buys section 1250 property that avoids the recapture problem and produces income to carry the land, and the three-property rule lets you identify both. If you will lease the land to a farmer or a developer, see exchanging into a ground lease.