Tax Myth # 538: All Real Estate Sales Qualify for 1031 Exchange Treatment
Most real estate investors and real estate professionals are familiar with the basics of the “1031 exchange” (also known as the “like-kind exchange”). In case you’ve been in a cave during the real estate boom, the basic idea of a 1031 exchange is that the owner of real estate or certain other property can defer the capital gain otherwise due on the sale of the property by reinvesting the sale proceeds in one or more “replacement properties.” By doing so, any capital gain is deferred until the replacement property is sold. By using multiple 1031 exchanges over time, savvy real estate investors can defer capital gains indefinitely, paying tax only when they take cash out at closing.
Sounds good, doesn’t it? With no taxes to pay, real estate investing starts to look extremely appealing compared to non-real estate investments. The problem is that many real estate investors are not “investors” at all; they are in the business of buying and selling real estate. They are, in IRS parlance, real estate “dealers”. Whether “flipping” properties for a quick profit or developing tracts of vacant land, these individuals may be surprised to learn that the IRS considers them ineligible for 1031 exchange treatment.
That’s right. It turns out that 1031 exchanges of real estate are permitted only for “investors”—not for real estate “dealers.” Likewise, the favorable long term capital gain tax rates of 5% and 15% are available only for gains realized from the sale of investments, not for ordinary income from a trade or business. This makes sense because otherwise real estate businesses would benefit from a huge tax break not available to other types of businesses.
So how do you determine if you are an investor or a dealer? This is one of those murky areas where the IRS applies a “facts and circumstances” test. Since a taxpayer can be an investor with respect to some real estate holdings and a dealer with respect to others, the determination is made on a property-by-property basis.
The courts have debated the dealer vs. investor issue numerous times, sometimes arriving at contradictory results. Some of the relevant factors are:
- The nature and purpose for which the property was acquired;
- The extent of improvements to the property;
- The number, frequency and substantiality of sales; and
- The amount of time the taxpayer devotes to sales efforts.
In short, proving that real estate is held for investment can be difficult, especially if the holding period is short or you make any improvements to the property. Tax reporting that is consistent with investment status (e.g., not deducting expenses that should properly be capitalized) may help, while inconsistent tax reporting will certainly hurt. As always, the best advice is to consult a tax professional for advice and assistance prior to any transaction.
Mark C. Neath, J.D.,CFPÒ, CBA, is a partner of Accel Tax & Business Services, LLC, which specializes in individual and business tax services, bookkeeping and consulting, business valuations, and financial planning. He can be reached at mneath@acceltax.com and through www.acceltaxandbusiness.com.
