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.
- The purpose for which the property was initially acquired
- The purpose for which the property was subsequently held
- The extent to which improvements, if any, were made to the property by the taxpayer
- The frequency, number and continuity of sales by the taxpayer
- The extent and nature of the transactions involved
- The ordinary business of the taxpayer
- The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
- The listing of the property with brokers, and
- 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.
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