Dealer-Developer Issues Can Jeopardize Your 1031 Exchange

If you do a number of 1031 exchanges every year, you should be aware of the Dealer/Developer issues. To qualify for a 1031 exchange, a taxpayer must be able to prove their “intent” at the time of purchase was to hold the property for investment.

According to the I.R.S., real estate held as “stock in trade or other property primarily for sale” is excluded from the tax benefits of Section 1031. Listed here are some factors the IRS uses to determine if there was intent to hold property for investment:

• Length of Ownership The nature and purpose for buying the property.

• Consistent with Investment Activity Has the tax-payer’s investment income and expenses on tax returns been consistent with investment activity? (It’s a good idea to NOT file a Schedule C for the 1031 property, or classify it as “inventory” or “held for development.”)

• Too Many 1031s A high number of 1031 Exchanges in a given calendar year. You don’t want to do so many 1031s in a given year that you might be considered “a dealer.”

• Too Much Control The length of leases, participation in rental activity, the amount of supervision or control by the taxpayer over representatives selling the property.

A common sense approach to this potential dealer/developer problem is to avoid frequent purchases, sales or other active involvement in the real estate business. Use separate entities to segregate development and sales activities from investment holdings. Attorneys have advised dealers to form a separate entity, such as an LLC, specifically to hold title of the property that might be part of a 1031 exchange sometime in the future.

Lastly, rely on professional advice from accountants and attorneys when structuring activities and transactions consistent with an investment motive.

...a taxpayer must be able to prove their “intent” at the time of purchase....