Capital Gains Tax Deferral for the Land Investor and Dealer
Given today’s real estate market where the lure to fix and flip is a part of mainstream reality TV, a question often in the mix is whether a 1031 exchange will defer the capital gains taxes? With the newly renovated property, the next step is to either hold or resell. If the property is resold within a year of the purchase, the short term federal and state capital gains taxes can eliminate upwards of 40 percent of the gross profit. Can a 1031 exchange defer these taxes is now a question the investor or dealer must understand.
Intent and Facts
The Internal Revenue Code Section 1.1031 allows taxpayers to defer the gain or loss when property held in a trade, business or investment is exchanged for like-kind property held in a trade, business or investment. The proper intent to qualify for a 1031 exchange is that the property is held in a business or investment, unlike inventory held on the shelf at the auto parts store for profit or resale. Facts supporting proper intent include:
- how long the property was held
- whether or not it was rented
- how was it itemized on the taxpayer’s federal tax return
- amount of personal use
The shorter the hold, the more substantial the facts will need to be. The IRC does not specify a hold time, but the Internal Revenue Service has stated in writing that two years is sufficient.
Investor vs. Dealer
Enter another set of facts to understand: whether the taxpayer is an investor or a dealer. Before rationalizing the taxpayer is always an investor, it is important to understand how the courts are determining this outcome. An investor with the intent to defer gain in a 1031 exchange will hold the property to allow it to season as an investment, including renting the property at fair market rent. Personal use is limited to fourteen overnights per year. To be fully compliant with Revenue Procedure 2008-16, the property will be held for two years and in each of those years, the property will be rented fourteen overnights. The replacement property will also be held for two years and in each of those years, the property is rented out a minimum of fourteen overnights per year at fair market rent.
A dealer or the taxpayer who owns multiple properties can fix and flip, along with 1031 exchanges, given the two are accounted for separately. The court considers the following facts as provided byKlarkowski v. C.I.R., T.C. Memo. 1965-328:
- The purpose for which the property was initially acquired
- The purpose for which the property was subsequently held
- The extent to which improvements, if any, were made to the property by the taxpayer
- The frequency ,number and continuity of sales by the taxpayer
- The extent and nature of the transactions involved
- The ordinary business of the taxpayer
- The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
- The listing of the property with brokers
- The purpose for which the property was held at the time of sale
The hard right decision, in the view of this qualified intermediary, is to pay the tax rather than pushing the envelope of a rationalized 1031 exchange. The surprise of an IRS audit is best offset with facts that support the proper intent.
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