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What Qualifies for 1031? Investment Property v. Inventory

yes-no-maybe dice 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 or used in a trade or business”. 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 that they buy to be “investment property” and are not aware of the specific “held for investment” criteria.

To begin to understand this clearly, we will need to first correct a common misconception. 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 lot and then builds a house on it with the intent to sell it. Even if the investor waits to close the sale with a buyer over a year after he bought the lot, the sale does not qualify for a 1031 exchange. The property was built to primarily to sell—not to be held for investment– and would be deemed inventory or “flip 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.

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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 property “held for investment”. A house considered inventory may not be depreciated, while a rental house (investment real estate) can. As a general rule, with the exemption of land, if you can’t depreciate something, you can’t 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, runs an ad, or lets her network know that she has a property for sale- she has indicated through her actions that she has the intent to treat her investment as inventory.

3. A good-faith effort to produce income from the investment 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. 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 unable to rent out the property. If you receive rent on the property and properly report it, you are establishing your intent to receive income from the property.

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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- 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 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 1031 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.

Perhaps fairly, 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 is 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 individual owners? 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 accidently convert long-term capital gain property into ordinary income property for tax purposes.

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Conversely, let’s consider a developer who buys 20 acres and builds a retail strip center. He immediately sells the land encumbered with the center, retains several outparcels and pays tax on the gain. Several years later, if he sells the remaining outparcels, will they then qualify for 1031 exchange treatment? They may. It depends on his intent at the time he sold the main retail center. If he planned to hold the outparcels for investment, did not advertising them for sale, and for accounting purposes reclassified them as capital assets, he may be able to exchange.

In summary, it is important for investors to be aware of these disqualifying actions. For investors who want their investment property to be able to qualify for a 1031 exchange, it’s advisable to only take actions that are consistent with the character of the property and it’s treatment. 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.