COVID-19 has caused a bloodbath on Wall Street and uncertainty in other investment classes, but for decades land has provided a safe haven for capital preservation during times of economic turmoil. In the post-pandemic economy, CPAs and their land-investor clients should understand what tax shelter options are available to them to protect their acquisitions.
Tax sheltering and land investing go hand-in-hand, according to Jason Walter and Clint Flowers, founder/CEO and partner, respectively, of National Land Realty.
“That’s because there [is] a myriad of tax sheltering options from which to choose,” said Walter. These include like-kind (Section 1031) exchanges, Delaware statutory trusts, depletion of tax basis, step-up in basis, retirement accounts, and conservation easements. Which ones are utilized all depends on the needs of the investor.”
1. Section 1031 exchange and DSTs
A 1031 exchange (a.k.a. a like-kind exchange), involves the exchange of an asset for another replacement asset without generating a current tax liability from the sale of the first asset. “Land is one of the types of investment real estate assets that is allowed to be exchanged,” said Walter. “This can easily be done through conventional sales and acquisition models, but also through Delaware statutory trusts, which allow investors to own a fractional interest in a certain property with other investors. Investing in a DST allows you to be a passive investor and diversify your real estate portfolio through investments across many different types and number of properties.”
DSTs are popular for the ownership of apartment buildings, according to Walter. “The DST allows multiple people to invest in a trust: For example, 30 investors might invest a million dollars each to buy an apartment building.”
2. Depletion of tax basis
Then there is the route offered by the depletion of tax basis, said Flowers: “For example, if you purchase timberland conventionally through a mortgage or for cash, and it has 4,000 MBF (thousand board feet) of merchantable timber worth $1 million on the day you bought it, you can convert that 4,000 MBF of timber into $1 million of income over time through one or more timber sales without incurring any tax consequences or capital gain.”
“It’s not a gain — it’s merely a recovery of capital,” said Flowers. “The timber was just converted to a liquid form. Every subsequent dollar after that would be taxed at the applicable long-term capital gain rate. Certain activities can add to the cost basis, enabling the holder to do deplete again later or capitalize in the year of the expense.”
3. Step-up in basis
This is the traditional step-up in basis when the owner of an asset passes away. The heirs receive the asset with a cost basis equal to the fair market value at the date of death. “For example, if an investor purchases land for $5,000 an acre and passes away when its current fair market value is $8,000 per acre, the heirs will receive it with a cost basis of $8,000 per acre,” said Flowers. “They would incur no penalty in selling the property unless their net income from the sale exceeds $8,000 per acre, and only the amount over $8,000 per acre would be subject to any capital gains tax, providing $3,000 an acre in tax shelter.”
4. Retirement accounts
Land can also be held in an IRA or 401(k), according to Flowers. “In the case of an IRA, it will have to be a self-directed IRA. For 401(k)s, you cannot invest directly into the 401(k) account, but will have to roll over your 401(k) into an IRA and then use the proceeds towards the investment” he said.
The IRA shelter is strictly limited to land that is used for investment purposes, according to Flowers: “So this is not the right choice for people looking to offset improvement costs of a cabin or lodge.”
5. Conservation easement
Conservation easements have been in the news lately, as the IRS has sought to thwart their use in abusive syndicated tax shelter transactions. However, the legitimate use of conservation easements is still recognized by the IRS.
“The IRS recognizes the important role of legitimate conservation easement deductions in incentivizing land preservation for future generations,” the IRS said in IR-2020-152, on July 13, 2020.
“Conservation easements resemble a deed restriction, but on a larger scale,” said Flowers. “Through this method, investors donate certain rights to the benefit of a charitable land trust. These rights are typically related to subdivision development, mining, or surface uses that might adversely affect the subject property’s wildlife or ecological benefit to the public, including air quality, water quality, etc. The more rights you donate, the bigger the tax shelter achieved. Through a conservation easement, anywhere from 50 to 100 percent of the donor’s adjusted gross income can be sheltered for up to 16 years.”
In addition to the tax shelter, conservation easements also offer donors the opportunity to set a positive example for their community. “And many times, they would have taken these conservation steps in order to make the best use of the land anyway,” Flowers noted.
Of course, given the current IRS focus, it’s very important for CPAs to distinguish between legitimate and abusive conservation easements. Rickard Jorgensen, president and chief underwriting officer of CPAGold, sees conservation easements as spiking the next wave of malpractice claims against accountants and tax preparers. This can take the form of a referral source to a syndicated conservation easement promoter; an aggressive deduction in the tax returns of a high-net-worth individual or a conservative deduction in the tax returns of an HNW individual.
“We recommend that a CPA firm should plan to take steps to mitigate the possibility of a claim arising from abusive syndicated conservation easement transactions,” he said.
Walter and Flowers agreed: “We’re highly involved in the integrity of the industry,” said Flowers. “If you buy and manage property and it has a higher and better use value, you can donate and achieve a nice tax deduction for doing something you would do anyway, that’s perfect — what it was designed for. But if you buy with the sole intent of achieving a return on a conservation easement, that most likely violates the charitable intent rule.”
