When it comes to qualifying for a 1031 exchange, not all investment property is created equal. IRS Code Section 1031 allows the exchange of property that is “held for investment.” Within this context, the meaning of the phrase “held for investment” is very specific. Property held for investment does not receive the same tax treatment as property that is held primarily for sale; in fact, investment property and inventory are accounted for differently on a tax return. The confusion arises because most investors consider any property they buy to have some investment potential. They are not aware that property used in certain ways will fall into a different classification. For tax purposes, the phrase “for investment” has a specific definition. There are three primary uses that will move a property into a different classification that does not qualify for 1031 treatment. These include property that is used as a primary residence, property that is used as a personal use 2nd home that is not rented out, and finally, property that is inventory. Inventory is also referred to as “property held primarily for resale” or “flip property.”
Let’s break down the meaning of the phrase “held for investment.” The “held” generally refers to the length of ownership. Many investors believe that once they have owned a property for 1 year and a day, they have then held the property long enough to qualify for a 1031 exchange. But length of ownership alone does not demonstrate, nor does it establish, the necessary intent. For example, consider an investor who buys a rental house well below fair market value and immediately lists the new acquisition with a broker at the higher fair market value price. Clearly, the intent is to make a quick profit. Assuming the property sells and closes within a three-month period of time, the investor could not do a 1031 because the property was used as property held primarily for sale, not for investment. Even if the investor stipulated that the new buyer had to wait one year to close, the sale may not qualify for a 1031 exchange: the signing of the listing agreement immediately after the acquisition coupled with no rental activity shows the original intent for a quick flip of the property.
Interestingly, the exchange requirements contain no specific rules that establish a minimum time that an investment property must be owned. Ultimately, whether or not an investment property qualifies for 1031 treatment depends more upon the owner’s intent, action steps taken during the period the property is owned and the related tax reporting. If any of the actions by the owner are not consistent with the accounting rules for “property held for investment”, then the property may not qualify.
There are five primary things to consider when deciding if a property will qualify for 1031 treatment:
1. The way the property is reported on your tax return is one factor. Inventory or property held primarily for resale is reported differently than other investment property. A spec house is considered inventory and may not be depreciated, while a rental house (investment real estate) can. Generally, if you depreciate it, then you can exchange it.
2. The length of time between when the property was acquired and was offered for sale is a second factor in establishing intent. If soon after acquisition an investor signs a listing agreement, puts a “For Sale” on the property, advertises the property, or lets her network know that she has a property for sale- she has indicated through her actions that she intends to treat her investment as inventory.
3. A good-faith effort to produce income with improved property is a third way that demonstrates intent. An immediate question is “did the owner rent it out?” There is an expectation for an investor to derive income from improved property. Just going through the motions, in an attempt to establish intent, does not appear to count. There are several tax court cases in which the rulings went against an owner that was asking double the market rate, and was thus unable to rent out the property. An investor should be in a good position to do a 1031, if they receive rent on the property and properly report it.
4. The steps taken while owning the property should not be similar to typical developer actions. If an investor buys (or already owns) property, has it zoned, subdivides it, builds improvements upon it and then sells it, all common developer steps, the investor appears to be treating the property as inventory. Note that this is property-specific and not person-specific (see below). A developer can do a 1031 exchange on property that he or she treats as “held for investment.” Likewise, an investor –who is not a developer by trade– can take “developer” action steps on his investment property and by virtue of those actions, convert it into non-qualified inventory.
5. Finally, the length of time the property is owned is a factor. A short period of ownership alone is not an automatic disqualifier, but it can appear suspicious leading to further inspection by an auditor to see if there are any other inconsistent facts. On the exchange reporting form 8824, your tax professional must list both the acquisition date and sale date of your properties. If this occurs in the same tax year, or even within months of each other, it could lead to further investigation.
To be fair, in deciding if a property will qualify for a 1031 exchange, it’s not what the property owner does professionally that counts, but how they treat their property. Let’s explore two practical examples. A Delta pilot bought 100 acres in North Georgia and has now owned it for five years. He properly reports this as investment property on his tax return. He has received an offer to sell the property for twice the original price. Under this scenario, can he do a 1031 exchange on this property? The answer is an unqualified yes. However, in an alternate scenario, let’s assume he becomes convinced that if he subdivides the property into four 25-acre parcels and sells them to separate individuals, that he can make even more of a profit. Using this strategy, can he do 1031 exchanges on the sales? Once again, the answer should be yes. He has held the property for investment.
But what if he is also considering subdividing the property in twenty 5-acre lots, putting in utilities and streets, and then selling the 20 lots to builders? Can he still do a 1031 exchange on the sales? In this scenario, he cannot. With these “developer” type actions, his investment property would be converted into inventory, and would not qualify for 1031 treatment. He would be wise to seek counsel before implementing this type of strategy because he may accidentally convert long-term capital gain property into ordinary income property for tax purposes.
Conversely, let’s consider a developer who buys 20 acres and builds a retail strip center. She immediately sells the land encumbered with the center, retains several outparcels and pays tax on the gain. Several years later, if she sells the remaining outparcels, will the sale qualify for 1031 exchange treatment? Maybe. It depends on her intent at the time she sold the main retail center. If she planned to hold the outparcels for investment, did not advertising them for sale, and for accounting purposes reclassified them as capital assets, she may be able to exchange.
In summary, it is important for investors to be aware of these disqualifying uses or actions. For investors who want their investment property to qualify for a 1031 exchange, it’s advisable to only take actions that are consistent with the “held for investment” guidelines covered above. It is always important to seek the opinion of your tax counsel when addressing these types of issues. Please feel free to contact us if you have questions or would like additional information.
