Dealer Status and 1031 Exchanges: Are You an Investor or a Dealer?

1031 exchanges cannot be performed with properties held “primarily for sale,” and if you’re classified as a dealer, intent will be much harder to prove.

IRC Section 1031 like-kind exchanges allow taxpayers to defer capitals gains, depreciation recapture, and certain other taxes on the sale of business or investment property when the sales proceeds are used to purchase a like-kind property. By deferring taxes, property owners can reinvest their full sales proceeds into new property, grow their businesses, and build more wealth for the future.

An important aspect of Section 1031 is that it only applies to property held “either for productive use in a trade or business or for investment,” and not to personal property or “property held primarily for sale.” In most cases, this should be easy to prove: if you own a retail location and operate a business out of it, or actively manage a multifamily apartment building for many years, you should have little trouble proving your property was held for business use.

But in other situations, proving a property was held as an investment can be more difficult. Some examples are when a former primary residence is now being rented out, or a vacation home used by the owner part of the year and made available on a short-term rental site for the rest of the year. In those cases, it’s necessary to prove that the intent behind holding the property was for investment and not just to resell.

Proving intent may require extra steps and documentation in order to satisfy the IRS. And for some exchangers, even if you consider your property to be an investment, your vocation may prevent it from being seen as such.

What is dealer status for 1031 exchanges?

If you buy land, develop it, and then sell the homes built on that land, you are engaged in a business, but that doesn’t mean your property qualifies for “use in a productive trade” or as an “investment.” Because you purchased the property with the sole intent of earning a profit from selling it once you increased its value, that is considered “property held primarily for sale.” In contrast, if you buy that same land, build on it, and then rent out the homes for a length of time, that would be considered business use.

What matters is your intention, both when you purchased the property and as you held it. If you had no other intent than “flipping” the property for a quick profit, then you can’t defer taxes through a 1031 exchange. For the most part, each property is considered separately from any other you may have exchanged.

An exception is when someone is considered a “dealer” of real estate. Those whose primary vocation is the flipping, developing, and/or sale of property are considered dealers and not investors. Any property sold as part of this kind of business would therefore be considered ordinary income from the business (which can’t be deferred through Section 1031) and not capital gains (which can be deferred through Section 1031).

So what if you’re classified as a dealer, but you also own property used for another business, or investment property you personally hold outside of your business?

Even if you aren’t flipping this particular home, your vocation as a developer could get you recognized as a dealer rather than an investor. That said, it isn’t impossible to execute an exchange even if you’re a dealer.

How is 1031 exchange dealer status determined?

Dealer status is inherently a gray area: if you flip one home, does that make you a dealer? There is no definitive threshold. It’s possible to develop real estate for a living and also own income-generating property on the side. But the tax benefits of a 1031 exchange are enticing enough to make it worthwhile for a developer to try and skirt the rules. That’s why each exchange must be evaluated on its own merits.

As with all 1031 exchange properties, proving intent matters: how long you held the property, the extent of the improvements made to it, whether it was rented or used for an income-generating business and for how long – all of this may be looked at. The nature of any improvements could also be scrutinized: fixing a leaky roof for tenants is a lot different from tearing down a building, constructing condominiums in its place, and selling each of those units once they are completed.

Intent can also change during the time a property is held. Buono v. Commissioner of Internal Revenue covers a situation in which a property was acquired with the intention of holding it for sale. But due to a series of outside factors, it was never subdivided or sold piecemeal. When a portion of the property was eventually sold, the court held that it was eligible to be treated as a capital gain because the sale didn’t fall under the owner’s normal course of business. Hence, a property purchased by a dealer with the intent of holding for sale became an investment property.

Other cases have also held that property held for investment, if substantial improvements are not made and the property is not subdivided, can be proven to be held for investment, even if the person’s normal business is as a dealer of real estate.

For those active in the industry who are likely to be classified as dealers, certain elements of the property sale and the owner’s business are likely to be scrutinized, including how often the owner makes property transactions and whether this transaction is similar to those performed under the normal practices of the owner’s business.

Also considered are the advertising and promotion done, whether the property was listed with a real estate broker, and at what stage in the development/improvement process these actions were taken. As with the holding period and other elements related to intent, there is plenty of gray area, but there are things you can do to make it more likely that your exchange will qualify for 1031 tax deferral.

How to increase the likelihood of a successful 1031 exchange

Proving intent can be tricky because there are no set rules regarding how long you should hold a property prior to an exchange. On one hand, this can be a good thing, because it allows for flexibility should you get an offer you can’t refuse; but on the other hand, you don’t want to get into an unnecessary legal battle with the IRS, so sometimes we all wish it were cut and dry.

The best strategy is to focus on what you can control, starting with getting proper tax and legal advice. Experienced counsel with knowledge of the relevant case history can give you a good idea of whether you will likely be considered a dealer and whether your exchange may have a shot at success. From there, you need to properly perform the important elements of an exchange, such as identifying replacement properties and doing so correctly in writing.

You also need to avoid constructive receipt of the sales proceeds from your relinquished property sale. For that, you need a Qualified Intermediary (QI), preferably one that takes extra steps to comply with all IRS regulations and properly documents each step so that if there is an issue where you need to provide proof of when and how certain actions were taken, you’ll be able to do so.

While the QI is an important element of an exchange, the QI industry is still largely unregulated. Going with a cheap QI can result in loss of funds, exchange failure due to violated rules, or improper documentation that can hurt your chances of appealing a decision. That’s why JTC has pioneered best practices for 1031 exchanges to ensure we provide the utmost in security, transparency, and compliance for our clients, so they can make the most of their exchanges.

Learn more about best practices in 1031 exchanges here.