March 9, 2023
By: Julia Mastrotto, Esq., Counsel
IRC Section 1031(a) provides that “no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” In short, to qualify for a tax deferred 1031 exchange, the property must be held with “investment intent.” IRC Section 1031(a)(1) specifically states that real property must be held for investment and real property “held primarily for sale” is specifically excluded from qualifying for a 1031 exchange in Section 1031(a)(2).
- “Dealer Status”
Dealers, wholesalers, and flippers, as they are called in the real estate industry, are terms for taxpayers (both individuals and business entities) that hold property primarily for resale. Property held for resale by dealers or wholesalers is generally not deemed to have been acquired with the requisite investment intent for both IRC §1221 (Capital Assets) and IRC §1031. A dealer/flipper of real estate is typically looking for a “rapid increase in price over a relatively short time, most frequently as a result of some efforts on [their] part to cause the increase,” i.e. making improvements or updates to “flip” the property for resale. The definition of “Capital Asset” in §1221 specifically excludes property held for re-sale in the course of business, by dealers.
An investor of real estate is usually “anticipating a gradual appreciation in value of the real estate, or a rather sudden increase in value in the event of fortuitous circumstances, without his doing much to cause that increase in value.” Generally, an investment property is held for greater than twelve (12) months in order to establish investment intent, whereas a “flip” property may be turned around in a much shorter time period.
Some taxpayers own rental properties that are primarily held for investment, but also own properties that the taxpayer seeks to flip for resale – in such case, the IRS must assess whether the individual exchange transaction qualifies under the “held for” requirement. “It is well established that a dealer in real estate may occupy a dual role: He may be a dealer with reference to some of his properties, and an investor as to others.” Ultimately, wholesalers, flippers, and dealers (those with “dealer status” with respect to certain real estate) are not eligible for a 1031 exchange. In a 1031 exchange analysis, Section 1031(a)(2) provides a much broader exclusion based on the intent of a taxpayer at the time they acquired the subject property. Because an exchanger will be not be eligible if they fail either §1031(a)(2) or the more narrow §1221 test for assessing dealer status, it follows that §1221 should be a starting point (See “Factors to Consider” below).
A special note should be made for the division of rental property into subdivided condominiums. The Tax Court in Gangi v. Commissioner analyzed whether subdivision into individual units changes the exchanger’s intent to “primarily for sale” or whether it remains that of a business or investment intent, if one was already established; in Gangi we lean toward the latter. The exchangers made no structural changes to the units themselves and no work was done to the building that would require a building permit. It should also be noted that selling the subdivided condos in one exchange to one buyer is generally a more conservative approach than selling units individually to multiple buyers; as mentioned above, this speaks to the contractor-intent as someone who deals in real estate in their ordinary course of business.
Considering the foregoing, the below factors may be assessed to determine if the taxpayer falls under “dealer status.”
- Factors to Consider
There is no singular test used to determine whether a property held by a taxpayer is being held primarily for resale in the ordinary course of their trade or business, however, a series of factors are considered:
(1) The purpose for which the property was initially acquired;
(2) the purpose for which the property was subsequently held;
(3) the extent to which improvements, if any, were made to the property by the taxpayer;
(4) the frequency, number, and continuity of sales;
(5) the extent and nature of the transactions involved;
(6) the ordinary business of the taxpayer;
(7) the extent of advertising, promotion, or other active efforts used in soliciting buyers for the sale of the property;
(8) the listing of property with brokers; and
(9) the purpose for which the property was held at the time of sale.
It is important to note that in analyzing factor 6, “the ordinary business of the taxpayer,” the Tax Court has said that the exception in §1031(a)(1)(A) [currently 1031(a)(2)] for real property held primarily for sale is a much broader standard than the exception to the characterization of property as a capital asset provided in §1221(a)(1); the difference being that “inventory” is property “held primarily for sale to customers in the ordinary course of trade or business.” This is distinct from situations where an exchange investor intends to re-sell property after a short holding period. In the latter, the intent is measured at the time of the exchange. Therefore, it is fundamental to distinguish that passing the “dealer” test under 1221 is not fully determinative of whether a property qualifies for 1031 purposes.
- The “Holding Period” and “Held for Investment”
The term “holding period” refers to how long a property must be held for investment in order to qualify for a 1031 exchange. Section 1031 and the corresponding regulations are generally silent on this issue with respect to relinquished or replacement property in a 1031 exchange. They only specify that said property be held “for investment.” In the past, drafts of Congressional legislation sought to codify a one (1) year holding period for both relinquished and replacement property, however, the version of the bill that passed did not include a mandatory holding period. Based on IRS guidance and case law related to IRC 1221 & 1222, it can be determined that if a taxpayer wishes to be conservative, they should hold property for at least twelve (12) months prior to exchanging said property in order to help substantiate that it was held for investment. It should be noted that this holding period is not a safe harbor nevertheless, and the determination is made on a case-by-case basis. A common misconception among investors transacting an exchange is that to qualify the property must be held for a minimum of two (2) years; this may stem from a misinterpretation of IRS Rev. Proc. 2008-16, which provides a safe harbor specific to residential dwelling units. See our article here. Generally, if a property is sold within twelve (12) months (quick turnaround), the IRS may infer that the taxpayer intended to profit off the resale of the property, instead of holding it as an investment.
For example, if a taxpayer acquires a property on day-1, places the property on the market or in-contract on day-90, but waits to sell the property until day-365, the IRS may still infer that the taxpayer intended to hold the property for resale, thus not qualifying for the tax deferral benefits of Section 1031; the reason for this is that the act of placing the property on the market or placing it under contract manifests an intent to sell on that date, even if the property is not physically sold until the 12th month.
Although not binding, Private Letter Ruling 8429039 states that a holding period of two (2) years is a “sufficient period to ensure that the residence to be acquired as the replacement property in a 1031 exchange, will meet the holding period test prescribed by section 1031.” This PLR predates Rev. Proc. 2008-16 but is a good example of a change in intent. The taxpayer originally received an adverse letter ruling when their initial application stated a fact pattern indicating a re-sale of the replacement property soon after acquisition. The IRS later approved the revised plan for a two-year hold.
In Black v. Commissioner, the Court found that a property sold only nine (9) months after its acquisition was “held primarily for sale,” and therefore did not qualify under Section 1031.
In addition to the rules for 1031 exchanges and capital assets (§1221), other provisions of the Tax Code are relevant. For example, IRC §1222 (1) & (3) provide that the difference between a short-term and a long-term capital gain is whether the capital asset has been held for more than a year.
Fundamentally, the foregoing information is intended as a resource to facilitate an educated discussion between the taxpayer and their tax and/or legal advisors regarding the taxpayer’s eligibility under IRC Section 1031. This article may only cover a portion of relevant authority on this matter and should be explored further. The IRS considers each exchange on a case-by-case basis, and no prior results guarantee those subsequent. As stated in Section 1031, the property must be held for “investment intent,” as property that is “held primarily for sale” is specifically excluded from qualifying for a 1031 exchange. Therefore, it is critical that a taxpayer speak with their tax and/or legal advisors regarding the related tax consequences.
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 Klarkowski v. Commissioner, Docket Nos. 3778-62 – 3780-62, 436-65 – 439-65., at *41 (T.C. Dec. 30, 1965).
 Id. at *41.
 Eline Realty Co. v. Commissioner, 35 T.C. 1, 5 (1960). See also Charles E. Mieg, 32 T.C. 1314, 1321; D. L. Phillips, 24 T.C. 435; Walter R. Crabtree, 20 T.C. 841; Nelson A. Farry, 13 T.C. 8.
 There is no one determinative test. “[E]ach case rests on its own facts and in most instances, it is unlikely that all factors will be applicable or of the same weight that they might have in another factual background.” Riley v. Commissioner, 37 T.C. 932, 938 (1962). See also C. E. Mauldin, supra; Gamble v. Commissioner, 242 F. 2d 586 (C.A. 5, 1957), affirming a T.C. Memorandum Opinion; Consolidated Naval Stores Company v. Fahs, 227 F. 2d 923 (C.A. 5, 1955).
 See Klarkowski at *54.
 Id. at *39-40. See also John D. Riley, 37 T.C. 932, affd. 328 F. 2d 428; C. E. Mauldin, 16 T.C. 698, affd. 195 F. 2d 714; Malat v. Riddell, 347 F. 2d 23, cert. granted 382 U.S. 900 (1965).
 See Klarkowski, supra; see also Neal T. Baker Enters., Inc. v. Comm’r, 76 T.C.M. 301, *7 (1998).
 See HR 3299, 101st Cong., 1st Sess (1989).
 Please note that this 12-month holding period is not a safe harbor and the determination is made on a case-by-case basis. In limited circumstances, the courts have upheld exchanges where relinquished property was held for less than 12 months.
 Black v. Commissioner, 35 T.C. 90, 91 (1960).