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Capital Gains Tax Deferral for the Investor and Dealer

Posted on | by Tom Gustafson | Leave a Comment on Capital Gains Tax Deferral for the Investor and Dealer

Given today’s real estate market where the lure to fix and flip is a part of mainstream reality TV, a question often in the mix is whether a 1031 exchange will defer the capital gains taxes? With the newly renovated property, the next step is to either hold or resell. If the property is resold within a year of the purchase, the short term federal and state capital gains taxes can eliminate upwards of 40 percent of the gross profit. Can a 1031 exchange defer these taxes is now a question the investor or dealer must understand.

Intent and Facts

The Internal Revenue Code Section 1.1031 allows taxpayers to defer the gain or loss when property held in a trade, business or investment is exchanged for like-kind property held in a trade, business or investment. The proper intent to qualify for a 1031 exchange is that the property is held in a business or investment, unlike inventory held on the shelf at the auto parts store for profit or resale. Facts supporting proper intent include:

  • how long the property was held
  • whether or not it was rented
  • how was it itemized on the taxpayer’s federal tax return
  • amount of personal use

The shorter the hold, the more substantial the facts will need to be. The IRC does not specify a hold time, but the Internal Revenue Service has stated in writing that two years is sufficient.

Investor vs. Dealer

Enter another set of facts to understand: whether the taxpayer is an investor or a dealer. Before rationalizing the taxpayer is always an investor, it is important to understand how the courts are determining this outcome. An investor with the intent to defer gain in a 1031 exchange will hold the property to allow it to season as an investment, including renting the property at fair market rent. Personal use is limited to fourteen overnights per year. To be fully compliant with Revenue Procedure 2008-16, the property will be held for two years and in each of those years, the property will be rented fourteen overnights. The replacement property will also be held for two years and in each of those years, the property is rented out a minimum of fourteen overnights per year at fair market rent.

A dealer or the taxpayer who owns multiple properties can fix and flip, along with 1031 exchanges, given the two are accounted for separately. The court considers the following facts as provided by Klarkowski v. C.I.R., T.C. Memo. 1965-328:

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent to which improvements, if any, were made to the property by the taxpayer
  4. The frequency ,number and continuity of sales by the taxpayer
  5. The extent and nature of the transactions involved
  6. The ordinary business of the taxpayer
  7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
  8. The listing of the property with brokers
  9. The purpose for which the property was held at the time of sale

The hard right decision, in the view of this qualified intermediary, is to pay the tax rather than pushing the envelope of a rationalized 1031 exchange. The surprise of an IRS audit is best offset with facts that support the proper intent.

Related articles of interest:

1031 Exchange: Dealer vs. Investor Status

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange: Dealer vs. Investor Status

According to Section 1031 (a)(2) of the Internal Revenue Code “property held primarily for resale to customers in the ordinary course of the taxpayer’s business” is considered inventory or stock and ineligible for a 1031 exchange. To qualify for the tax deferral treatment, the property should be held in productive use in business or investment. Distinguishing between the dealer and investor status of the property is crucial for determining 1031 exchange eligibility for the transaction.

Dealer vs. Investor Intent

Dealers hold inventory for resale. The sale of inventory results not in a capital gain tax but in ordinary income tax. Realtors and developers who own and sell real estate can be considered a dealer depending upon the facts that support their intent.

An investor purchases real and personal property and holds the asset for typically more than one year allowing the acquisition or investment to season. When the investor sells, a capital gains and recaptured depreciation tax is triggered . The intent or initial motivation of the investor is to hold versus a quick sale as in a flip where the seller’s intent is for resale.

Dealer vs. Investor Questions

Nine questions provide the criteria used by the courts to determine whether the taxpayer fact pattern represents a dealer or investor.

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent to which improvements, if any, were made to the property by the taxpayer
  4. The frequency, number and continuity of sales by the taxpayer
  5. The extent and nature of the transactions involved
  6. The ordinary business of the taxpayer
  7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
  8. The listing of the property with brokers, and
  9. The purpose for which the property was held at the time of sale

There is no one determining factor, however the court looks to the frequency and substantiality of the transactions.

Good Supporting Facts for Realtor and Developer

How the realtor and developer account for the property’s income and expenses is one set of facts that supports an investor status. Realtors and developers who in their normal course of business sell real estate, can own investment properties under another titleholder or entity and maintain a separate set of books. Making improvements to land begin to take on dealer status when roads and utilities are installed. Homes can be built for resale as a dealer while other houses may be held in a rental pool qualifying for nonrecognition under Section 1031.

Each exchange has an intent when the property is initially acquired and a set of facts supporting it. The intent and factor pattern help to determine ultimately whether the taxpayer is either a dealer or investor subject to ordinary income or capital gains tax respectively.

Ask the Certified Exchange Specialist on staff a question and receive the answer within twelve hours or less.

Share this article with your collegues and friends on face book and twitter.

1031 Exchange: Dealer vs. Investor Status

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange: Dealer vs. Investor Status

1031 Exchange Dealer vs Investor StatusAccording to Section 1031 (a)(2) of the Internal Revenue Code “property held primarily for resale to customers in the ordinary course of the taxpayer’s business” is considered inventory or stock and ineligible for a 1031 exchange. To qualify for the tax deferral treatment, the property should be held in productive use in business or investment. Distinguishing between the dealer and investor status of the property is crucial for determining 1031 exchange eligibility for the transaction.

Dealer vs. Investor Intent

Dealers hold inventory for resale. The sale of inventory results not in a capital gain tax but in ordinary income tax. Realtors and developers who own and sell real estate can be considered a dealer depending upon the facts that support their intent.

An investor purchases real and personal property and holds the asset for typically more than one year allowing the acquisition or investment to season. When the investor sells, a capital gains and recaptured depreciation tax is triggered . The intent or initial motivation of the investor is to hold versus a quick sale as in a flip where the seller’s intent is for resale.

Dealer vs. Investor Questions

Nine questions provide the criteria used by the courts to determine whether the taxpayer fact pattern represents a dealer or investor.

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent to which improvements, if any, were made to the property by the taxpayer
  4. The frequency, number and continuity of sales by the taxpayer
  5. The extent and nature of the transactions involved
  6. The ordinary business of the taxpayer
  7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
  8. The listing of the property with brokers, and
  9. The purpose for which the property was held at the time of sale

There is no one determining factor, however the court looks to the frequency and substantiality of the transactions.

Good Supporting Facts for Realtor and Developer

How the realtor and developer account for the property’s income and expenses is one set of facts that supports an investor status. Realtors and developers who in their normal course of business sell real estate, can own investment properties under another titleholder or entity and maintain a separate set of books. Making improvements to land begin to take on dealer status when roads and utilities are installed. Homes can be built for resale as a dealer while other houses may be held in a rental pool qualifying for nonrecognition under Section 1031.

Each exchange has an intent when the property is initially acquired and a set of facts supporting it. The intent and factor pattern help to determine ultimately whether the taxpayer is either a dealer or investor subject to ordinary income or capital gains tax respectively.

Ask the Certified Exchange Specialist on staff a question and receive the answer within twelve hours or less.

Share this article with your collegues and friends on face book and twitter.