Buy land with 1031, then build?

Question

Greeetings! I could use some advice on my 1031 options. I own and rent out a NYC 1BR co-op currently worth around $400K while living in the city suburbs (in a SFH that I own with my husband). We are planning to relocate to a lakefront area, with a target move date sometime in the next two years. I was loosely planning to list the co-op for sale next spring after my long-term tenant's lease expires in March 2024, in order to have cash on hand for the new home purchase. I was not planning to seek out a new investment property in the new location - I have learned over the last few years that being a landlord is not really for me.

However, my tenant threw a wrench into my plans yesterday - she informed me her offer to purchase a co-op elsewhere was just accepted, so if the purchase goes through, she could be moving out in as little as two months (we discussed the possibility of her buying my unit, but she wants 2BR). Obviously, she'd be breaking the lease and on the hook for rent, but I am required to mitigate her damages by trying to find a new tenant (or other solution). Co-op requires new lessee to sign a new one-year lease minimum, but I'm not sure I want to bring in a new tenant starting in May/June given the timeline above.

Listing for sale now is also an option, and I feel like this may present an interesting opportunity for a 1031 given our two-year relo horizon. I understand that we could simply find a house that we would like to live in, buy it and rent it out for two years to meet the safe harbor requirement, and then move into it as our primary residence. However, we are also interested in the possibility of building a home. Is it possible to use the 1031 to buy a lot, build a house on it, and then use that house as a rental for a year (or two) to meet the safe harbor before moving in? The cost of the lot would probably equal or exceed the sales price of the co-op, so we'd get a construction loan and/or HEL on our primary residence to fund the build. I have been researching but I can't seem to find a definitive answer on whether this is allowed.

Thanks in advance for your insight - I'd appreciate any other creative ideas you may have for this situation. Cap gains/other taxes on this sale will probably be upwards of $50K so it's worth a bit of hassle (and another couple of years of landlording) to avoid them.

Whitney Nash · Answer

Hello @Amber S.Yes, you can sell your rental and 1031 the funds into buying the land, building a house on it to rent for two years and then move into it as your personal residence. If you have more questions about doing the 1031 exchange, please feel free to DM me.

Amber S. · Answer

Got it, that makes perfect sense. Thank you!

Dave Foster · Answer

@Amber S. almost but not quite. Your net sale is the contract price (400K) minus closing costs (call it $350K). Your net proceeds would be around $220K (350 - 130). In order to defer all tax in this scenario you must purchase at least $350K using all $220 of proceeds. There's a great video on our website and youtube channel that explain even better.

Amber S. · Answer

I see, you mean if my co-op sells for $400K I would have to invest that amount less the mortgage balance (currently $130K) and any other closing costs (i.e. realtor fees, city sales taxes, etc.), regardless of my actual basis in the property (around $160K)? Or would I be required to reinvest the full $400K? It's probably irrelevant in this case because either a lot or a house in our new location is likely to exceed the sales price on the co-op, but still, something to keep in mind.

Dave Foster · Answer

@Amber S., wait! The regs for 1031 are that if you want to defer all tax you must purchase at least as much as your net sale. And you have to use all of the proceeds in your next purchases. You're not just using the profit. Any amount you purchase less than you sold. Or any cash you take the IRS will call profit until it reaches the $250 - $200 mark. They won't let you take your original basis out without paying tax on profit. I don't think I can attach an overview here. So I'll reach out via pm.

Amber S. · Answer

Perfect, this is what I needed to know. The co-op sale will probably result in 200-250K of taxable gains, and either a lot or a house will exceed that amount, so the 1031 funds would be fully reinvested through that purchase. We'd be financing any improvements or a new build separately.

Dave Foster · Answer

@Amber S., You still have to get the improvements done in the 180 days before you take title. An improvement exchange is another form of a reverse exchange where the QI takes title and holds until your improvements are done. You only need this if you need the improvements to equal your reinvestment target for the 1031. If the new property satisfies those requirements by itself then you're good to go. and your plan of buying and then renting for two years before you convert and improve is a splendid play.

Amber S. · Answer

Ah, I didn't realize that the new build would have to be a reverse exchange and completed within 180 days - that is definitely too tight a timeframe. With a house that needs improvement, does that have to be done as a reverse exchange as well? Or can that be done as a regular 1031 if the house is in good enough shape to rent out immediately? For instance, we sell our apartment this summer and use the 1031 funds to purchase an older but still livable rental home on August 1, 2023. We rent the house to a third party until September 1, 2024, meeting the 14-day requirement in two separate 12-month periods. Then we renovate while still maintaining a primary residence elsewhere, and move in on August 2, 2025, satisfying the 2-year safe harbor. Is this allowed?

Dave Foster · Answer

@Amber S., the process you're describing is form of a "reverse exchange". In a reverse exchange the QI for the 1031 takes title to the lot. And while the QI is on title to the lot you improve it. Then you complete your 1031 exchange by purchasing the lot with the improvements on it from the QI at your cost of the improvements. It works very well except for a couple of things.1. These are quite a bit more expensive than a regular 1031 exchange and will cost you several thousand dollars more.2. You only get 180 days from the day we take title to the lot for you to complete your 1031 exhange and buy the lot and improvements from us. This can cause a bit of a problem because new construction will almost always take too much time.However a reverse improvement exchange where you find an actual house you like on a lake that needs improvements. These can generally be done during the 180 day period. Just something else to consider :)

Amber S. · Answer

Thank you Whitney! We are just beginning to explore the possibilities for 1031 but I will be sure to reach out with further questions. Finding an existing house would certainly be simpler than buying land and building, but it's nice to know that land is an option should a perfect opportunity present itself.