How diversified is your portfolio? Do you see yourself as an investor? For some people, a diversified portfolio is one invested in different types of stock investments. For others, a diversified portfolio is one invested in various forms of real estate. A truly diversified portfolio invests in different kinds of assets, stocks, real estate, commodities, etc.
One investment option overlooked by many investors is raw land.
What is it?
Investing in raw land involves the purchase of unimproved property, often with the intent of building, leasing, or selling the land at a later date.
Investing in raw land may be as simple as purchasing a single lot in a subdivision on which to build a home, or as complex as accumulating hundreds of unimproved acres to hold for future development and subdividing.
Speculators often invest in raw land, acquiring tracts of land in anticipation of future rezoning.
Regardless of your position and purpose, the success of an investment in raw land depends on a few important factors.
Among these factors are the location and physical features of the property itself, the timing of the investment, the opportunity cost of the investment (i.e., the value of other opportunities you may be sacrificing), and, in the case of a large-scale investment, whether the community and local governing bodies are supportive of the development.
Caution: There are inherent risks associated with real estate investments and the real estate industry, each of which could have an adverse effect on the financial performance and value of a real estate investment.
Some of these risks include a deterioration in national, regional, and local economies; tenant defaults; local real estate conditions, such as an oversupply of, or a reduction in demand for, rental space; property mismanagement; changes in operating costs and expenses, including increasing insurance costs, energy prices, real estate taxes, and the costs of compliance with laws, regulations, and government policies. Real estate investments may not be appropriate for all investors.
What are the risks?
The success of an investment in raw land depends largely on future events that cannot be accurately predicted. In many cases, you are taking a gamble that future conditions will create demand for your property, and that someone (a developer, builder, or prospective homeowner) will be willing to pay a great deal of money for it. If things don’t work out as expected, you could be stuck with a worthless piece of land.
When should it be used?
You understand the risks associated with raw land, and you are comfortable with them
All real estate investments carry a substantial degree of risk.
However, raw land is probably the riskiest of all real estate investments. Numerous factors can affect the profitability of the investment, and most of these are beyond the control of the investor.
For this reason, it is imperative that you measure your risk tolerance so that you understand the risks associated with this type of investment.
You have the knowledge and nerves required to be successful
In order to be successful in investing in real estate, you must have (or be willing to work on acquiring) knowledge of the real estate business as a whole, the specific property you are purchasing, and the community surrounding it.
You need to be able to recognize trends in the area. You also need nerves of steel, especially if you are banking on political or economic changes that will precipitate development and make your property more valuable.
You may want to hire a professional in the real estate field if you lack the knowledge and nerves required to be successful.
What are the strengths?
Raw land provides greater opportunity for creativity and profit than any other real estate investment
Raw land is an extremely flexible investment. There are as many ways to use it (subject to zoning and other laws) as there are investors with ideas.
Each investment in land is different, and each provides a unique opportunity for profit. Variables that make raw land so flexible include the amount of down payment, investment purpose (e.g., residential building, commercial building, speculation), holding period, and selling method (e.g., installment sale, cash sale, lease).
These numerous variables allow you to create an investment that best suits your needs.
Investing in raw land may provide certain tax benefits
As a real estate investor, you are allowed to deduct your operating expenses from the gross income produced by your investment.
Typically, not many operating expenses are associated with raw land, but property taxes and loan interest may be deductible expenses (depending on how the property is used).
There may also be some cleanup costs if there is debris, natural growth, or contamination of the soil or groundwater. These may be expensed, and some costs may have special tax treatments.
You may purchase liability insurance and/or fence in the land; the costs of these programs may be deducted on your tax return. You should discuss specific cases and methodology with your tax advisor.
What are the tradeoffs?
Risk level is higher than other real estate investments
Raw land is probably the riskiest type of real estate investment. More than other types of investment properties, raw land is affected by uncontrollable outside events, such as economic and political changes in the area, acts of nature, zoning changes, or court decisions.
Thus, a property that appears to have vast profit potential can become almost worthless overnight. It is imperative that you understand the risks you are undertaking when you invest in any type of real estate.
There is no guarantee that you will realize a profit on any real estate investment. In fact, there is no guarantee that your property will even retain its current value.
Raw land does not provide all the tax benefits of other real estate investments
Unlike other real estate investments, raw land is not a depreciable asset. Improvements that are permanently attached to the land are depreciable as real property, as are certainly other improvements such as landscaping. However, no depreciation is allowed on the land itself.
How to do it
Decide what type of raw land investment you want to make
Since there are numerous types of raw land investments, it is important to find the right method of investing. You’ll need to decide whether you want to lease the land, sell it outright, or build to suit.
You’ll have to choose whether you want to buy land for retail or commercial development, for residential building, or for a more speculative venture. You’ll need to figure out how large an investment you want to make, whether it be a single lot or thousands of acres.
Evaluate prospective properties
Choosing the right property is crucial to the success of your investment. The tricky part of evaluating raw land is that you must always consider the future use of the property, not just its current state.
Among the factors to consider are the location and physical features of the property itself, the timing of the investment, the opportunity cost of the investment, and, in the case of large-scale investment, whether the community and local governing bodies are supportive of the development.
To gauge the value of the land and the potential of the investment, it may be helpful to investigate similar parcels of land in the area that have been sold recently.
Raw land provides limited tax benefits
Investing in raw land may allow you to deduct certain expenses, but it does not provide the tax shelters that many real estate investors seek.
Unlike other real estate investments, raw land is not a depreciable asset. The reason for this is that land is not exhausted over time or subject to wear and tear, as a building would be.
Improvements that are permanently attached to the land are depreciable as real property, as are certainly other improvements such as landscaping.
However, no depreciation is allowed on the land itself. For this reason (and many others), it is typically not a good investment for beginners.
On the flip side, raw land can be an excellent tool for generating capital gains, which receive favorable tax treatment compared to rental income or other types of income.
In many cases, raw land generates no income at all, which means that you, as the investor, do not have to worry about current income taxation.
In effect, you can defer taxation on any appreciation in value until you sell the property. Thus, you can potentially generate a profit by eventually selling the property at a higher price than what you paid for it and paying taxes in the future at lower capital gains rates.
But, if the property loses value and you wind up selling the property for less than its cost basis, you will have a capital loss. Generally, capital losses can be used only to reduce or offset capital gains.
Excess losses can then offset up to $3,000 of ordinary income per year ($1,500 if you are married and file separately), assuming your taxable income is at least as much as the deduction.
Losses remaining after the limit may be carried forward indefinitely to offset future income.
Also, net capital gains from the sale of the property will be included when calculating whether your total investment income is subject to the 3.8% tax that applies to individuals with an adjusted gross income (AGI) above $200,000 and couples filing a joint return with more than $250,000 AGI.
So, if raw land is not currently part of your portfolio, do your research to determine if it’s right for you.