Under Internal Revenue Code Section 1031, exchange of “stock in trade or other property held primarily for sale” will not qualify for tax deferral. Consequently, most properties owned by developers, builders, and people who perform rehabilitation work (“flipping”) are likely to be considered held primarily for sale and therefore may not qualify for exchange treatment. For example, homes built by a homebuilder are considered stock in trade or inventory and cannot used for a 1031 exchange. In addition, taxpayers who acquire property, renovate it and then sell it are likely considered to be holding the property for sale rather than for investment purposes.
In an audit, the IRS looks at whether a taxpayer intended to hold the property being exchanged for investment purposes (in which case the exchange would be valid) or “primarily for sale” (in which case the exchange would likely be invalidated). What the taxpayer does before or after the exchange may provide the IRS with evidence of one’s intent. The three most important factors that a court will look at in determining a taxpayer’s intent are:
- The frequency, number and extent of the real estate transactions entered into by the taxpayer;
- The development activity of the taxpayer, which includes subdividing, grading and improving the property; and
- The nature and extent of the efforts by the taxpayer to sell the property.
The taxpayer must have intended to hold the property for investment or use in the taxpayer’s trade or business at the time of the disposition of the property. However, the courts have also held that a taxpayer may later change its intent and still qualify for tax deferred exchange treatment.
There is no bright line test for determining how long one must hold property in order to establish that they intended to hold it for investment purposes. Many tax advisors recommend holding property for at least one to two years in order to establish evidence of intent to hold for investment purposes. However, in some circumstances, such as where an exchanger receives an unsolicited offer that is far above market value, it may be possible to prove the requisite intent, even without holding the property for a year or more.
As always, one must discuss their specific circumstances with a CPA or tax advisor in order to make a determination on whether a property in question would qualify for tax deferral under section 1031.
Please speak with your tax advisor and contact one of our 1031 exchange experts for more details.
If you or someone you know has questions about the 1031 exchange process, we at Peak 1031 Exchange are your qualified experts who are here to help. Contact us today at [email protected] or by calling us at 866-357-1031 to discuss the deferral of capital gains taxes with a 1031 exchange.