Selling Land

Capital Gains Tax Deferral for the Land Investor and Dealer

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:

  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 by the taxpayer
  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 the property with brokers
  9. 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.

This content may not be used or reproduced in any manner whatsoever, in part or in whole, without written permission of LANDTHINK. Use of this content without permission is a violation of federal copyright law. The articles, posts, comments, opinions and information provided by LANDTHINK are for informational and research purposes only and DOES NOT substitute or coincide with the advice of an attorney, accountant, real estate broker or any other licensed real estate professional. LANDTHINK strongly advises visitors and readers to seek their own professional guidance and advice related to buying, investing in or selling real estate.

About the author

Andy Gustafson, CES

Andy Gustafson, Certified Exchange Specialist®, is a managing member of Atlas 1031 Exchange, LLC, a nationwide accommodator of Internal Revenue Code Section 1031. He founded the company in 2007, and has since expanded his professional services into Texas and the Midwest. He has spoken to hundreds of investors at Wealth Camps and Real Estate Investment Clubs nationwide and is a sought after speaker on the topic. As an approved continuing educational provider, he has helped hundreds of Realtors, Attorneys, and CPAs understand the application of the 1031 code. To date he has accommodated over 500 exchanges representing $433,000,000 in exchanged value and deferring over $22,000,000 in taxes.

4 Comments

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  • thanks, this article is very well done and informative. if you have a mailing list, please place me on your list, maybe we can do some business. John

  • Andy this is an informative and helpful article. One thing I’ve never seen on a house flipping show on A&E is what the sellers are paying in taxes after they do their deal. That tidbit would probably be a surprise to a lot of first-time flippers. Thanks again for sharing.

  • Hello Jonathan, you are right about the tax consequences. If the property sold is held less than one year and depending upon the state, the taxes can easily represent 40 percent of the selling price. Before considering a short term hold, understand the tax outcome.

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