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Can Property Developers Use 1031 Exchanges?

Max Hansen, JD, CES®
11/15/23
For a valid 1031 Exchange, the IRS requires property to be held for business or investment use. In this article, we closely examine the meaning of "held for" as it pertains to the 1031 Exchange requirements and given those requirements whether Dealers or Developers are eligible for a 1031 Exchange of their real properties.
Developer Property Eligibility for a 1031 Exchange

Generally, 1031 Exchange s cannot be utilized to acquire real property that will be remodeled or otherwise improved or developed and resold, because the “qualified use” requirement contained in Code Section 1031 requires that the taxpayer have a bona fide intent at the time of acquisition to hold the property for productive use in a trade or business or for investment.

Flip Properties

That being said, there have been situations involving 1031 Exchange s by taxpayers with dealer/developer histories but varying fact patterns similar to the scenario described above where taxpayers have claimed the 1031 deferral and the IRS and courts have looked at the facts of each specific case in determining eligibility for 1031 deferral.

In determining if a property is being acquired and held by the taxpayer for purposes of resale to the taxpayer’s customers in the ordinary course of the taxpayer’s business,it is incumbent to devine the bona fide intent of the taxpayer at the time of acquisition and during the ownership period to determine whether the 1031 Exchange is valid.

Arguably, if the taxpayer has a bona fide intent at the time of acquisition to hold the property per the 1031 Exchange regulations and an unsolicited buyer comes along a couple weeks later and offers them twice what they paid for the property and the taxpayer sells, the taxpayer has met the qualified use requirement. What better investment is there? Another example is where the taxpayer gets a new job in a different area and the taxpayer cannot manage the property he or she recently acquired. One more example is a when a property is bought and the taxpayer makes every effort to rent it, but it does not get rented and has a buyer who is willing to acquire the property for another purpose.

From a practical standpoint, the taxpayer and their CPA must deal with the Form 8824 that is filed for that transaction involving a 1031 exchange. The form asks when the taxpayer acquired the real property described in the relinquished property contract and qualifying as “relinquished property” and when they sold it. A short holding period raises a red flag despite the taxpayer’s bona fide intent. The taxpayer may win the ensuing argument, but could spend more than the taxes on attorney and CPA fees. The taxpayer should always follow the guidance of their qualified CPA or other tax advisor in regard to the tax reporting.

Criteria in distinguishing 1031 Exchange Property from “Dealer” Property

As stated above, various criteria are often evaluated by those in the 1031 Exchange industry in determining whether property qualifies for Section 1031 treatment as opposed to being “dealer/developer” property. The criteria include the following:

  • What is the initial purpose for which the property was purchased?
  • What was the purpose for which the property was later held?
  • What is the extent to which the taxpayer made improvements if any such as subdivision, roads/streets construction, utilities and other infrastructure build-outs, actual residential construction, etc.?
  • What is the taxpayer’s frequency, number, and consistency of property sales?
  • What is the size and type of transactions involved?
  • What is the taxpayer’s regular business?
  • What is the extent to which advertising, promotion, or other active efforts were made to recruit buyers for the sale of the property?
  • Was the property marketed with brokers?
  • What is the reason and purpose for which the property was held at the time of sale?

Some cases that involved a determination of the validity of a 1031 Exchange on a property that was acquired for resale include: Redwood Empire Sav. & Loan Ass’n v. Comm’r, 628 F.2d 516, 517 (9th Cir. 1980); Pool v. Comm’r, 251 F.2d 233, 237 (9th Cir. 1957); Evans v. IRS, T.C. Memo. 2016-7 (January 2016); Paullus v. Commissioner, 72 T.C.M. 636 (1996).

AAdditional Tax Planning Options for Developers: Section 1227 Unrelated to a 1031 Exchange : Developers and their advisors may gain some comfort from Section 1227 of the Code which allows some taxpayers to sell up to five lots and pay long term capital gains tax on the proceeds. However, there are strict standards which must be met in order to obtain that benefit such as holding the properties for 5 years.

Summary

Sometimes it is hard to determine if a developer or a flipper is eligible for 1031 treatment. There is no explicit rule, rather it is a “facts and circumstances” test as to the property in question. A developer or flipper could have a long history of acquiring property and selling it in a short time-period, but a specific property property they own may have long been held as an investment or income producing property. Obviously the taxpayer’s intent at the time the property was acquired and the ability to substantiate that intent is key. Hopefully, the answers to the bullet points above can help a taxpayer or advisor determine whether tax deferral through Section 1031 is viable in connection with a particular piece of property.

 

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified  Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.