This article identifies the types of property which are §1031 like-kind property and distinguishes those that do not qualify as §1031 property in a real estate transaction.
Qualified to sell or buy under §1031
Properties owned either for productive use in a trade or business, or for rental or other investment purposes are referred to as either like-kind property or qualified property in a §1031 reinvestment plan. [Internal Revenue Code §1031(a)(1)]
The profit taken on the sale of real estate (or personal property) is exempt from income tax if both the real estate sold and the real estate purchased qualify as Internal Revenue Code (IRC) §1031 like-kind property in the hands of the owner seeking the profit tax exemption.
Property which does not qualify as §1031 property, called unqualified property, unlike-kind property or simply other property, includes:
dealer property, such as inventory items and real estate bought for resale rather than for business use, (rental) operating income or for increase in value due to appreciation or inflation [IRC §1031(a)(2)(A)];
stock (although it can be issued in exchange for real estate under a §351/§1032 tax-exempt exchange) [IRC §1031(a)(2)(B)];
bonds, such as certificates of indebtedness or interest-bearing obligations issued by corporations or government entities [IRC §1031(a)(2)(B)];
promissory notes, whether secured or unsecured, that are sold or purchased, such as carryback notes [IRC §1031(a)(2)(B)];
other security devices or evidences of indebtedness that are similar to security devices, such as post-dated checks or assignments of payment rights held by trust deed lenders to evidence debt [IRC §1031(a)(2)(C)];
choses in action (payment rights or rights to receive future payments), such as a seller’s (assignable) interest under a purchase agreement [IRC §1031(a)(2)(F)];
beneficial interests in a trust (other than a revocable inter vivos trust) [IRC §1031(a)(2)(E)];
foreign real estate located outside the U.S. [IRC §1031(h)]; and
fractional interests in co-ownerships conducted as tax partnerships (although an interest in a partnership can be issued by a partnership in exchange for its receipt of real estate as a §721 tax-exempt exchange). [IRC §1031(a)(2)(D)]
Also, properties exchanged between related persons must be held for two years, called a holding period, by both persons before the profit made on the sale of the property exchanged is exempt and the property acquired is qualified as §1031 property for sale or further exchange. [IRC §1031(f)(1)]
If a resale of property exchanged between related persons occurs within two years, the property acquired is considered disposition property in the hands of the seller under the exchange and fails to be like-kind property. The exchange no longer qualifies for the §1031 exemption.
Additionally, depreciable property used productively in a trade or business has a one-year holding period before it qualifies to be sold or exchanged as §1031 property. After one year of ownership, business-use property can then be sold or exchanged as §1031 property. [IRC §1231(b)]
Investment vs. trade or business property
Section 1031 (like-kind) property consists of two classifications of property:
investment property, called capital assets [IRC §1221]; and
trade or business property. [IRC §1231]
Thus, the principal residence of the taxpayer does not qualify as §1031 property (even though it is a capital asset) since it is not used in a business or held for investment purposes.
Investment property includes:
rental properties, residential and nonresidential;
vacation homes held for profit or resale; and
investment (portfolio) real estate. [IRC §1221]
The investment property does not include property held primarily for sale to customers of the owner’s trade or business, called dealer property. Inventory and other dealer property, such as subdivided lots, land held as builder inventory or properties purchased at auction for the purpose of renovation and resale, are held for immediate sale in the ordinary course of the owner’s trade or business. Dealer property does not qualify as property used in a trade or business even though it is owned by the trade or business. [IRC §1231(b)]
Like investment property, real estate used as the premises which houses the owner’s trade or business or the operation of a hotel or motel is §1031 property.
Unlike investment property, trade or business property must be owned for a one-year holding period before it qualifies as like-kind property to be replaced in a §1031 reinvestment plan by acquiring trade or business property, rentals or investment property. [IRC §1231(b)(1)]
Similarly, rentals and investment property can be sold and then replaced by trade or business property, rentals or investment property in a §1031 reinvestment plan.
Small investors can exchange too
Many novice investors owning one-to-four unit properties and small businesses whose business occupies a building they own mistakenly believe §1031 benefits are available exclusively to wealthy investors who own large income projects. However, no investment or business-use property is too small (or too big) to qualify for §1031 tax-exempt treatment. The property’s dollar value is irrelevant.
By planning his sales and acquisition, an investor can build his estate (personal net worth) and avoid the diminution of wealth wrought by profit taxes on the sale of unwanted property. The investor need only coordinate a §1031 reinvestment plan to sell, avoid receipt of the net sales proceeds and identify and acquire replacement property with the proceeds.
Also, a leasehold interest in real estate qualifies as §1031 property if the remaining term of the lease period exceeds 30 years, including options to extend or renew. [Revenue Regulations §1.1031(a)-1(c)]
No limitations are placed on size, value and location of the property involved in a §1031 reinvestment plan, as long as the properties are located within the United States. An owner can reside in California, sell Texas real estate and purchase Hawaiian replacement property.
A §1031 reinvestment plan can involve the sale of one or more parcels of undeveloped real estate and the purchase of one or more parcels of improved real estate, for use in a business or to be operated as rentals.
The reverse is also true, but until 2006, it may trigger ordinary income reporting for the recapture of excess accelerated depreciation taken on improved property purchased in 1985 or 1986.
Two or more investors may be brought together in a “syndicated” transaction, called a consolidation exchange. Each investor sells his solely owned like-kind property and consolidates the net sales proceeds with those of other investors, each acquiring a fractional interest in one replacement property which itself qualifies as §1031 property.
For example, a $30,000 equity in one parcel of real estate plus a $70,000 equity in another parcel of real estate can be sold and replaced with a single parcel of real estate with an equity of $100,000 or more.
However, the reverse is not always true. The sale or exchange by one investor of his fractional co-ownership interest in §1031 property that requires less than unanimous consent to sell or exchange, refinance or lease, such as occurs in the co-ownership of rental property under a limited liability investment (LLC), does not qualify the investor’s separate interest as §1031 property for a reinvestment plan. [IRC §1031(a)(2)(D)]
Section 1031 tax-free reinvestment of sales proceeds encourages estate building into bigger, more efficient and more suitable properties. The tax which would otherwise have been paid on the profit made from the property sold is retained, working for the investor.
Thus, an investor will have more after-tax dollars working for him if he sells his property and buys replacement property in a §1031 reinvestment plan. Conversely, he can cash out, report profits, pay capital gains taxes and then reinvest the greatly diminished after-tax funds.
Adaptation for §1031 treatment
Taxwise, an owner usually holds real estate for one of four purposes:
immediate resale for business income, called inventory, dealer property or disposition property;
business use, such as real estate in which the owner operates his trade or business;
investment for rental income from operations or long-term profit on resale; or
personal use, such as the owner’s principal residence.
Property held for immediate resale to customers in the ordinary course of a real estate business, such as lots in a subdivision or new construction, is referred to as dealer property or inventory.
Dealer property is business inventory, not property used productively for the operation of the business or a capital asset such as a rental. Dealer property generates ordinary income on resale, not profits as occurs on the resale of a productive property held and occupied by the business for more than 12 months. Thus, the sale of dealer property is not entitled to §1031 tax-exempt benefits or capital gains tax treatment when sold. [IRC §§1031(a)(2)(A), 1231(b)]
Property used in a business or held for investment, such as unimproved land, can later be reclassified as dealer property and can no longer qualify as §1031 property. This transformation can occur at any time during ownership.
The owner alters the tax status of his ownership by simply modifying his intent and conduct in his use of the property. For example, an owner shifts his goals from holding property for investment or business use purposes to retail sales purposes by initiating plans to subdivide land previously held for investment and then marketing the resulting parcels for sale.
Stock in trade (inventory/dealer property) is specifically excluded from qualifying for the §1031 profit reporting exemption since it is held and marketed to be sold in the ordinary course of business. Thus it generates ordinary income on its sale, not a profit. [IRC §1031(a)(2)(A)]
Residential and nonresidential rental properties, being capital assets called rentals, qualify as §1031 investment property.
Property held for investment
Capital assets make up the investment classification of §1031 property unless selectively excluded. Capital assets do not include:
inventory (dealer property) [IRC §1221(a)(1)];
§1231 property used to house a business (however, this does qualify as §1031 property under trade or business assets when held for more than one year) [IRC §1221(a)(2)];
copyrighted material and literary, musical or artistic compositions held by the creator of the material or the person for whom it was produced [IRC §1221(a)(3)];
accounts receivable, such as unpaid rent [IRC §1221(a)(4)]; and
government debt obligations, such as treasury bills, notes and bonds. [IRC §1221(a)(5)]
Real estate, furnishings, stamps/coins, gems, paintings, antiques, precious metals, manuscripts and other valuables held for long-term appreciation qualify as capital assets, unless held or acquired for immediate resale as inventory in a trade or business.
For example, an owner has several individual residential rental properties held for investment and one residence held for his personal use.
The residences held for investment (rental) purposes can be sold and purchased in a §1031 reinvestment plan. However, an owner’s personal residence does not qualify as §1031 property since it is not owned and operated as either a rental or to house his business.
Yet, a personal residence qualifies as a capital asset since it is not excluded from the definition of an IRC §1221 asset. Thus, profits upon sale of a personal residence which are not excluded from taxes under the $250,000 IRC §121 exclusion are reported as capital gains, not ordinary income (and any capital loss is disallowed since it is a personal loss).
A leasehold estate in property that has a remaining period of over 30 years on the lease term (including extension or renewal periods), fee or equitable ownership of residential and nonresidential rentals, vacation property and land held for long-term profit are investment properties. Thus, they qualify as §1031 properties.
Property used in a trade or business
Trade or business property includes real estate used primarily by the owner to house and operate his trade or business. Trade or business property is not strictly classified as a capital asset. For purposes of §1031 treatment, trade and business property is subject to a different holding period, after which it is “treated” as a capital asset for profit tax purposes.
To qualify as §1031 property on its sale or exchange, business property must first be held by the owner for more than one year. [IRC §1231(b)]
Examples of property used in a trade or business include land and its nonresidential improvements, parking lots, timberland, hotels, motels, inns and vacation rentals not personally used by the owner.
Property not considered trade or business property, even though owned by the business, includes:
inventory property, such as lots or homes in a subdivision created by the owner [IRC §1231(b)(1)(A)];
dealer property, bought to be immediately resold, or held to be improved and sold [IRC §1231(b)(1)(B)];
copyrights [IRC §1231(b)(1)(C)];
timber, coal or domestic iron ore [IRC §1231(b)(2)];
livestock [IRC §1231(b)(3)]; and
unharvested crops on land used for trade or business – unless the land is held for more than one year and the crop and the land are sold or exchanged at the same time and to the same person. [IRC §1231(b)(4)]
Disposition property: §1031 nullified
Replacement properties acquired in a §1031 reinvestment plan that are to be immediately resold in a cash-out sale or conveyed to another individual or taxable entity are called disposition property and do not qualify as §1031 property. The attributes of ownership regarding the use and operation of disposition property by the owner are the same as for dealer property.
When replacement property is acquired on the sale or exchange of other property and put to some dealer activity, such as promptly cashing out or subdividing, restoring, renovating, building or improving the property and then immediately reselling it in a cash-out sale, the disposition disqualifies the replacement property as §1031 property.
These properties acquired with the intent to cash out on a resale are tainted with the intention to manage them as dealer property, often by spending time and effort to prepare them (and upgrade them) for resale. Simply put, the properties are acquired to be upgraded and “flipped” for a profit in a cash-out sale as inventory of a trade or occupation. [Little v. Commissioner of Internal Revenue (9th Cir. 1997) 106 F3d 1445]
Property purchased by an individual to complete a reinvestment and is promptly conveyed or sold to a corporation under IRC §351 (in a tax-free exchange for the issuance of stock) is not classified as property acquired by the individual for productive use in a trade or business or for investment. It is disposition property. The owner immediately on acquisition conveyed it to an entity (the corporation) that is a separate taxpayer. [Revenue Ruling 75-292]
Conversely, when an owner acquires replacement property and later deeds it to a partnership or LLC for the same percentage of ownership as the percentage he held in the replacement property, such as in a syndicated exchange or a consolidation exchange, the further conveyance is not a disposition of the property.
The further conveyance to a partnership or LLC does not alter the tax impact on the owner who previously or concurrently acquired title to property on his completion of a §1031 reinvestment. The income tax reporting by the owner after acquiring the property produces the same tax result whether he retains title or further deeds the property to a partnership or LLC. However, this is not so for further conveyances to a corporation on completion of a §1031 reinvestment. [Magneson v. Commissioner (1985) 753 F2d 1490]
