from IPX1031.com
Most owners of real estate will tell you that if they bought a property for $75,000 and sold it a month later for $100,000, that it was a great investment. If they deferred paying the capital gain tax on their sale by utilizing a 1031 exchange, well they are not just a great investor, but a genius to boot. Unfortunately, that is exactly what the IRS may determine: that the capital gain tax our investor tried to defer is just that, “boot”, and our investor will not just pay capital gain tax of 15%, our investor will pay short term capital gain tax, as the asset was held for less than a year.
So, what then should an investor do so that the sale of property
qualifies for 1031 treatment?
The intent by the taxpayer to hold property “primarily for sale” and not “primarily for investment” will prevent the property from qualifying for IRC 1031 treatment. While in general, most properties owned by developers, builders and people looking to fix up and re-sell will probably be considered to be held primarily for sale and may not be allowed tax deferral treatment, the IRS looks to the intent of the taxpayer in determining whether the property qualifies for tax deferral treatment. In determining the Exchanger’s intent, the IRS will look at the intent at the time of the sale. At the time of disposition of the property, the Exchanger must be determined to have intended to hold the property for investment or use in the Exchanger’s trade or business. Three factors that the IRS will look at that can determine whether the taxpayer’s property was “held for sale” and does not qualify for tax deferral exchange treatment are:
The frequency and number of real estate transactions entered into by the taxpayer.
The more property sales by the Exchanger, the more likely IRS will find that the property is “held for sale” and does not qualify for exchange treatment. The best example of this is the Investor who buys foreclosed/distressed properties, fixes them up and then immediately attempts to “flip” for a quick profit.
2. The development activity of the taxpayer such as subdividing, grading and
improving property.
This looks at the taxpayer’s development activities, such as subdividing the property, adding streets, roads, sewers, utility services, rezoning and renovating the property. In these situations, the IRS is looking at the extent that the gain on the sale of the property was attributable to the taxpayer’s own efforts to the property as opposed to a gain due to external factors. Note that simply subdividing a property will not necessarily prevent a taxpayer from receiving exchange treatment on the disposition of the property.
3. The nature and extent of efforts by the taxpayer to sell the property.
This is the sales efforts of the taxpayer. This includes advertising efforts, use of sales personnel, a sales office to sell individual lots in a subdivision, was the property multi listed with a broker. The IRS will look at the proportion of the Exchanger’s income that is derived from the sale of the property, and the extent of the taxpayer’s involvement, time effort and control over the sales activities regarding the property.
As you may have noticed, the time factor alone (how long the property was held by the taxpayer prior to sale) is not what determines intent. Exchangers are always advised to consult with their tax and legal advisors regarding the exchange status of a property prior to selling their property.
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