At first glance, a 1031 exchange might seem like a smart way to reinvest proceeds from the sale of developed real property, especially if you are planning to roll those profits into your next project. But the IRS draws a line between real estate being held for investment or business purposes and real estate held primarily for sale.
A Real-World Scenario
A developer recently posed this thoughtful question:
“We developed a 20-unit condominium complex. Twelve units have been sold, and the proceeds paid down our construction loan. We have since paid off the balance and have some net proceeds. The last eight units will soon sell. Can we roll all (or some) of the proceeds from these final sales into a new parcel of land for development using a 1031 exchange?”
This is a great question and the answer is: it depends on the specific facts and circumstances.
Why All Real Estate Doesn’t Qualify for 1031 Exchange
When real estate held for investment or productive use in a trade or business is exchanged for like-kind property, Section 1031 of the Internal Revenue Code allows for the deferral of capital gains tax.
However, property held primarily for sale, such as property developed with the intent to sell to customers, is excluded from 1031 treatment.
This is spelled out in IRC §1031(a)(2):
“This subsection shall not apply to any exchange of real property held primarily for sale.”
In short: if your property is considered “inventory” in the eyes of the IRS, rather than held for investment, 1031 tax deferral is not an option.
How the IRS Determines “Held for Sale”
Courts look at a variety of factors to make this call, including:
Why you acquired the property
How long you held it
What improvements you made
The number, frequency, and permanency of sales
The scale and substance of your transactions
The nature of your business
Whether you marketed the property
Whether you used brokers or listing services
(Cited cases include Mathews v. Commissioner, 315 F.2d 101 (6th Cir. 1963) and Gardner v. Commissioner, T.C. Memo. 2011-137.)
If your activity looks more like a development business rather than long-term investment holding, the IRS may view the property as held for sale even if you only develop occasionally.
Development Projects and the “Dealer” Trap
In our condo example, the developer created a project with the intent to sell individual units. That’s a red flag for the IRS. Paying off a construction loan, profiting from individual unit sales, and rolling the gains into new land for further development mirrors the activities of a property dealer, not a long-term investor.
While it’s possible that some portion of the project might qualify, it’s a gray area that could lead to an audit or challenge. This is why consulting a qualified tax advisor early in the process is essential.
See if Your Property Qualifies for 1031 Exchange
1031 exchanges are powerful tools, but not all real estate deals qualify. If you are a developer or builder looking to defer taxes on your next project, it is important to understand the IRS rules and how your specific facts stack up.
When in doubt, get professional advice. Every situation is unique, and your tax advisor can help you evaluate your eligibility and avoid costly surprises.
Thinking about a 1031 exchange? Feel free to call me, Jeff Peterson, at 612-643-1031, or email me at jeffp@CPEC1031.com.
Defer the tax. Maximize your gain.
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