To qualify for the tax benefits of an exchange under Section 1031, the property you want to exchange (or relinquish) needs to be “held for productive use in a trade or business or for investment.”
For income tax purposes, real estate is divided into four classifications: (1) property held for business use, (2) property held for investment, (3) property held for personal use, and (4) property held primarily for sale (“dealer property”).
Only property that is held for business and property held for investment qualify for an exchange under Section 1031.
Property held for personal use and property held primarily for sale do not qualify.
Section 1031 does not define either “held for productive use in a trade or business” or “held for investment,” but over time, court cases and IRS rulings have clarified what these terms mean in most instances.
Examples of property that is “held for productive use in a trade or business” and clearly qualify for a Section 1031 exchange include all buildings owned and used by a business, such as factories and office buildings, as well as rental apartment buildings.
Examples of property that do not qualify for a Section 1031 exchange are stocks, bonds, or notes, certificates of trust or beneficial interest, choses in action (a right to recover money or other personal property in a judicial proceeding), or other securities or evidences of indebtedness (with the exception of a 30-year or longer lease).
It does not matter if any of the excluded property items are related to real estate; they are always excluded from Section 1031 exchange.
For example, a note can never qualify for a Section 1031 exchange, even if the note is secured by real property.
Also disqualified from exchange under Section 1031 is inventory, stock in trade, or any other property that is held primarily for sale rather than business use or investment (known as “dealer’s property”).
Property is considered inventory, and therefore not qualified for a Section 1031 exchange, when it is held for sale to customers in the ordinary course of business. For example, if you own a business that sells airplanes, you cannot use one of those airplanes as qualified property for a Section 1031 exchange.
The dealer property exclusion rule also means that real property held for sale by dealers in real estate does not qualify for Section 1031 exchanges.
In determining who is a dealer in real estate, the IRS looks at the facts and circumstances of each case and makes its determination on a property-by-property basis.
While there are no hard and fast rules in this area, in general, the questions the IRS asks are: what is the nature of the taxpayer’s business; for what reason and purpose was the property acquired and/or transferred; for what length of time was the property held; what are the number and frequency of sales; what kinds of construction improvements and subdivision activity was undertaken on the property; did the property have income-producing potential; and what is the percentage of real estate sales as compared to the taxpayer’s other income.
It is important to note that you do not have to be in the business of buying and selling real estate to be treated as a dealer by the IRS. If you are required by the buyer of the relinquished property to undertake subdivision activities or other work in preparation for the buyer’s development of the property, you may be considered to be in a joint real estate venture with the buyer, and the IRS could disqualify the exchange as involving dealer property.
Similarly, an exchange under Section 1031 is not available for real estate “flippers.” “Flipping” property refers to the practice of buying real estate and then quickly reselling it (with or without making improvements) at a higher price.
Property that is “flipped” is not eligible for the tax benefits of Section 1031 for the same reason as the exclusion of dealer’s property. As noted, dealers in real estate may not use Section 1031 because they hold real estate for resale (that is, as stock-in-trade or inventory), and a quick resale (or attempted exchange) of recently acquired real estate signals to the IRS that the property is being used for inventory, not for productive use in a trade or business or for investment.
The bottom line is that you must remain aware of the requirement that both the relinquished and the replacement properties be held for use in a trade or business or for investment rather than resale. If the IRS concludes that either the relinquished property or the replacement property is held by the taxpayer for the purpose of resale rather than use in a trade or business or for investment, then the property will be disqualified from the Section 1031 exchange process
and capital gains taxes must be paid.
In deciding whether a particular property has been held for productive use in a trade or business or for investment, the IRS looks at how you have characterized that property on your tax returns. If you have historically taken depreciation on or reported rental income on a property, there should not be any problem with that property qualifying for a Section 1031 exchange.
Property that does not now qualify for a 1031 exchange can be recharacterized for tax purposes by using it for a trade or business or for investment.
Although there is no absolute rule regarding exactly how long the property must be held for use in a trade or business or for investment before it is recharacterized and can be exchanged – and the IRS insists that it will examine each exchange on a case-by-case basis – most professionals recommend planning for a holding period of two years.
In any event, the best way to ensure that this requirement is met is to consult with both your attorney and your tax advisor regarding the potential for any holding period problems in your agreement with the buyer for your relinquished property, as well as your future plans for your replacement property.
For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.
To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to email@example.com
For Part One of this article, click here.
For Part Three of this article, click here.