Land Banking & 1031 Exchange

Land banking is not a new concept. It is described as the process of separating real estate activities by forming different business entities that perform investment functions while others complete development activities.

Let's say an investment group forms an LLC and purchases a tract of land for a long-term investment. Over the years, development moves closer to the land and the land increases in value. Perhaps the property is annexed into a municipality, the zoning is changed and a new four lane highway appears. The group decides that, rather than sell it "as is", they would further profit by taking the land through development of the parcel. But wait, they've held it for a long time and they realize that if they develop it, they will get taxed at ordinary tax rates instead of the long term capital gain rate - which is significantly lower. But what if they form a new entity to develop the property? Ah....land banking!

Thanks to a series of favorable court rulings over the past couple decades, owners can sell a property to a separate corporation they control. This corporation then develops the horizontal (and perhaps vertical) improvements and markets the land. By doing so, the former entity - in our example, the LLC - can potentially save significant tax liability on the appreciated value of the land when it is sold to the related corporation by classifying the investment as a long-term capital gain! Jim Walker, the senior tax partner of at the firm Rothgerber Johnson & Lyons LLP explains this process more fully in his article "Land Banking:" A Structured Approach to Capital Gains Planning.

So what would happen if the owners of the LLC decide ahead of the sale that they'd like to reinvest the proceeds of the land sale, to the related corporation, via a 1031 exchange rather than pay the 15% Fed cap gains tax (plus any applicable state or local tax) in order to fully defer the tax?

There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs. Under this thinking, the development corporation would be compelled to hold the land purchased from the LLC for two years before reselling it.

Tax and exchange professionals have historically advised their clients to comply with the two year rule. However, three Private Letter Rulings (PLRs) released in 2007 say that the two year rule did not apply to a related party who purchased the relinquished property from the taxpayer. The legislative history of Section 1031 identifies several situations intended to qualify under this provision. It includes a non-tax avoidance exception that applies to transactions not involving the shifting of basis between properties.

The purpose of the rule is to prevent related parties from shifting basis from a high basis asset to a low basis asset in anticipation of the sale of the low basis asset that would reduce gain recognition. However, the exchanges in the three PLRs treated the exchanges as valid even though the related buyer voluntarily disposed the property it acquired within two years of the purchase. The rationale used in the 2007 Private Letter Rulings was that the exchanging taxpayer was the only entity that owned property before the exchange. The development corporation did not own property prior to the exchange. Thus, the subsequent disposal did not result in "basis shift" or "cashing out".

So is it possible to land bank a property separating the investment and development activities between entities and then subsequently have the investment entity exchange property? It would appear so - based on recent rulings. Clearly, one need get their legal and tax professional included early on in this process to ensure that you've structured a case that will stand up to potential audit. You also should use the services of a Qualified Intermediary that understands related party issues and knows how to properly process the exchange.