Property that is traded in a 1031 exchange must be held for investment purposes or for use in the owner’s business. For example, if you own a building in which your business is located, or if you own an office building and rent it to tenants, that property can be traded in an exchange.
What does not qualify?
Stock in Trade and Dealers
Property that you hold primarily for sale cannot be traded in a 1031 exchange. Internal Revenue Code Section 1031 specifically says that it doesn’t apply to any exchange of “stock in trade or other property held primarily for sale.” This issue comes up in different ways. First, if you are a homebuilder, the homes you sell are stock in trade or inventory, and you cannot do an exchange with those homes.
In addition, if a regular part of your business is selling real estate, you can be considered a “dealer” and the properties you sell will be properties held for sale rather than held for investment purposes. There are cases analyzing the difference between dealers and investors, and one of the most important factors is how often you sell real estate in the ordinary course of your business.
Held Primarily for Sale
Even if you are not considered a dealer and your properties are not considered inventory, you may be holding property primarily for sale. If so, you will not be able to trade that property in a 1031 exchange.
Taxpayers who acquire property, renovate it and then sell it may be considered to be holding the property for sale rather than for investment purposes. This can be true even if the taxpayer is not a dealer and owns the property for more than one year. The relevant factor is that the taxpayer intended to improve the property and sell it rather than hold it for income.
The IRS looks to what your intent was at the time of the exchange, but what you do before or after the exchange may provide them with evidence of your intent. For example, if you acquire property in an exchange and sell it within thirty days, the fact that you sold it so quickly can be evidence that when you acquired it you intended to sell it rather than hold it for long term income.
How long do you have to hold property in order to establish that you intended to hold it for investment income? There is no bright line test, but many tax advisors recommend holding property for a year or two to establish evidence of intent to hold for investment purposes.
Taxpayers theoretically can establish investment intent even when they sell property sooner than the one year mark. One example of this would be if a taxpayer acquires property with the intent to hold it for investment purposes but receives an unexpectedly high offer from a buyer within months of the exchange. The less time the taxpayer owns the property the more evidence that will be required in an audit to prove that the property was held for investment rather than for sale. On the other hand, as mentioned above, even if you own property for a year, there may be enough evidence to prove that you intend to hold it for sale rather than investment purposes.
It’s important for you to discuss your transactions with a tax advisor. In addition, please contact First American Exchange if you have any questions or want to set up an exchange.
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