One of the key rules for a real estate exchange to qualify for capital gains tax deferral under section 1031 is that the property involved was held for either investment purposes or for productive use in trade or business. In many cases, this is a straightforward thing to show.
However, questions may arise as to whether this strict requirement has been met when the exchanger works in real estate for a living.
For example, if you are an exchanger who regularly buys and sells real estate or flips properties for profit, the IRS will scrutinize your exchange differently than if you were a casual real estate investor. That doesn’t mean you are prohibited from the world of 1031 exchanges, only that you must be careful to segregate that activity from day-to-day broker operations.
It is important to know the factors the IRS scrutinizes when considering your exchange. This will help you avoid unnecessary denials when it comes time to file your tax return.
The biggest thing the IRS will look to is your intent. Subjective? Absolutely. But while it is a somewhat amorphous and intangible thing to determine, the IRS does have some criteria that guides them to their final decision.
Although non-exhaustive (and keep in mind that every exchange is unique), the following general factors will help the IRS determine intent:
- The nature and purpose of the property acquisition
- The duration of ownership
- The extent and nature of the investor’s efforts to sell the property
- The number of sales executed by the investor
- The use of a business office for the property sale(s)
- How much control the investor exercises over the actual seller of the property (if the parties are different)
- The amount of time the investor regularly devotes to sales
- The ordinary course of business of the investor