Can You Use a 1031 Exchange for Profits from Real Estate Development?

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:

1. Why you acquired the property

2. How long you held it

3. What improvements you made

4. The number, frequency, and permanency of sales

5. The scale and substance of your transactions

6. The nature of your business

7. Whether you marketed the property

8. 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.

© 2025 Copyright Jeffrey R. Peterson All Rights Reserved     

Video – Important Players in a 1031 Exchange: CPA or Accountant

At CPEC1031, LLC we are great qualified intermediaries who can facilitate the mechanics of your 1031 exchange. However, we’re only allowed to wear one hat in the exchange – that of the neutral unbeholden third party. There are a lot of other people that you may need at some point in the process to help you make an informed decision and to have the necessary inputs for a successful 1031 exchange.

Many times, taxpayers need to bring their existing accountant or tax advisor into the decision making process. Your accountant is going to know what the depreciation schedule is on the old property. They’re going to know what your remaining basis is. Basis is critical in a 1031 exchange because your gain is not how much cash proceeds you walk away with, but rather the difference between your current adjusted basis and the net selling price. So even though you walk away from closing with little or no cash proceeds, you may have an enormous gain because your basis may have been whittled down over years of depreciation.

Your accountant is critical in helping you make an informed decision. Without your accountant, your transaction is like an airplane that doesn’t have any instrumentation.

Your Like-Kind Exchange Resource – CPEC1031, LLC

The qualified intermediaries at CPEC1031, LLC are your go-to resource for all things related to section 1031 of the Internal Revenue Code. Our team is ready and waiting to guide you through the like-kind exchange process from beginning to end, ensuring that you are comfortable and well-informed every step of the way. Reach out to us today to learn more about the 1031 exchange process and see how you can save money with a 1031 exchange by reinvesting into a bigger, better replacement property.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2025 Copyright Jeffrey R. Peterson All Rights Reserved

PIGs (Passive Income Generators): A Smart Strategy for Unlocking Passive Income and Building Wealth

In the world of real estate investing and tax planning, there is a saying worth remembering: “Pigs get fed, hogs get slaughtered.” When it comes to generating passive income and making the most of your passive losses, it pays to be the right kind of pig: a Passive Income Generator, or PIG.

Why Passive Income Matters

Passive income is the dream: money that shows up whether you are laboring or not. But in the tax world, the IRS has its own definition and a strict set of rules about what counts as passive activity and how losses can be used.

Back in 1986, the Reagan administration rewrote the rules with the Passive Activity Loss (PAL) limitations, designed to shut down abusive tax shelters. The result? The losses from passive investment activities can only be used to offset the income from other passive investment activities. That’s where PIGs come in.

The Problem: Trapped Losses

Real estate investors often find themselves with passive losses they cannot use, at least not immediately. Unless your income is under certain thresholds, or you qualify for one of the key exceptions, those losses just sit there.

Here are the three most common paths to unlock those losses:

1. The $25,000 Passive Loss Allowance: For rental property owners under certain income limits, this exception allows up to $25,000 of losses to be used against non-passive income.

2. Real Estate Professional Status (REPS): Qualifying as a real estate professional allows you to treat rental activities as non-passive, but the requirements are strict and well-documented.

3. Short-Term Rental (STR) Loophole: If your average rental stay is 7 days or less, and you materially participate, those rentals may be treated as non-passive, even without REPS status.

But what if none of these apply?

The Strategy: Find a PIG

Enter the Passive Income Generator (PIG), an investment that produces income without material participation. When the income is passive, it can unlock the value of your passive losses.

Think of a PIG as a tool in your wealth-building toolbox. It does not reduce your taxes on its own but when paired with existing passive losses, it can create meaningful tax savings and improved after-tax cash returns.

What Qualifies as a PIG?

Not all “hands-off” investments qualify as passive under IRS rules. Here are some examples that do qualify:

• Real Estate Limited Partnerships (RELPs): You invest capital, receive distributions, and leave the operations to someone else.

• Rental Properties (when the management is outsourced): If you are not materially involved, your income is passive.

• Private Equity Real Estate Funds: These funds are designed for limited partner investors, providing income and potential appreciation without active participation.

• Peer-to-Peer Lending: Returns from P2P platforms can generate passive income in the form of interest.

On the other side of the spectrum, here are a couple of examples that do not qualify as passive investments under IRS rules:

• Dividend Stocks, Real Estate Investment Trusts (REITs) or Capital Gains: While they may feel passive, this is technically portfolio income, and it cannot be used to offset passive losses. Under Treasury Regulation §1.469-2T(c)(2 & 3), portfolio income is not considered income from passive activity and that includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business.

• Your Own Business (if you materially participate): Even if you are not grinding it out every day, your involvement may still be deemed active under IRS rules.

Use Caution, Not Just Optimism

A true PIG isn’t just a tax strategy; it is an investment. That means due diligence is critical. Before jumping in, ask:

• How much income will this realistically generate?

• What’s the risk profile?

• What’s the liquidity and redemption policy?

• Does the tax benefit justify this investment?

The goal isn’t just to feed your losses; it is to feed your future wealth.

PIGs and the Bigger Picture

Finding and funding a PIG is a strategic move for investors who have already done the hard work of building a portfolio and accumulating passive losses. When used wisely, PIGs can accelerate your returns and reduce your tax liability without requiring you to qualify as a real estate professional or convert to short-term rentals.

But don’t forget the bigger picture: a good PIG should stand on its own as a solid investment. The tax benefit is icing on the cake, not the cake itself.

Think Like a Strategist

When it comes to wealth building, passive income plays a powerful role, but the IRS rules mean it is not as simple as “make money while you sleep.” Understanding the role of PIGs, and how to unlock passive losses with passive income, can make all the difference in your long-term strategy.

Think carefully. Choose wisely.

• If you are considering 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.

© 2025 Copyright Jeffrey R. Peterson All Rights Reserved

Qualified Intermediaries: Why You Need One for Your 1031 Exchange

A qualified intermediary is an important element in any 1031 exchange of real estate. In this article, we are going to explain the role of the qualified intermediary and discuss why you need one for your 1031 exchange of real estate.

The Importance of a Qualified Intermediary

There are many important professionals you want to have on your team when embarking on a 1031 exchange of investment real estate. You should involve your CPA or accountant, your attorney, your real estate broker, a good title company – just to name a few. Perhaps the most important professional you want to engage in a 1031 exchange is a qualified intermediary. A qualified intermediary (or QI for short) is a professional that specializes in the facilitation of like-kind exchanges under section 1031 of the Internal Revenue Code.

Your qualified intermediary can guide you through the 1031 exchange process – making sure you understand all the rules and benchmarks that you need to satisfy in order to defer your capital gains taxes. They can also help prepare important documentation during the exchange. The most important role that a QI plays is that of a neutral third-party that insulates the taxpayer conducting the exchange from receiving any of the net proceeds from the sale of the relinquished property. Taking constructive receipt of any sales proceeds would trigger taxable boot (and thus result in a partial or failed exchange). Your intermediary holds the funds on your behalf and then reinvests them into the replacement property so you can defer 100% of your capital gains taxes.

Call a Qualified Intermediary at CPEC1031, LLC to Start Your Exchange

Interested in learning more about the tax-saving potential of a 1031 exchange? Call a qualified intermediary at CPEC1031, LLC today to start the exchange! We have more than twenty years of experience working with taxpayers across the United States on 1031 exchanges of all types (forward, reverse, build-to-suit, etc.) and we can help you through the details of your like-kind exchange. You can find us at our primary Twin Cities office located in downtown Minneapolis.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2025 Copyright Jeffrey R. Peterson All Rights Reserved

What Happens If My 1031 Exchange Partially Fails?

Understanding Tax Implications When a 1031 Exchange Doesn't Go as Planned

A 1031 exchange is a powerful tool for deferring capital gains taxes on the sale of investment real property. But what happens if the like-kind exchange doesn’t fully succeed? Maybe you could not identify a replacement property in time, or you chose not to reinvest the entire sale proceeds. Does that mean you are automatically hit with a huge tax bill?

Not necessarily, but partial exchanges do trigger tax consequences that should be understood ahead of time.

Understanding Boot and Partial 1031 Exchanges

When a taxpayer conducting a 1031 exchange receives cash or non-like-kind property as part of an exchange, that portion is known as "boot" and it is taxable to the extent of the realized gain.

It’s a common misconception that you can receive your “original basis back” tax-free. In actuality, the IRS taxes gain before basis is recovered when boot is received. So, if your relinquished property sells for $500,000 and you have $300,000 of basis, any boot received is first applied against your gain, not your basis. “Boot” triggers recognition of gain, and that gain is taxed before any remaining basis is returned to the taxpayer. Why does this happen? In a 1031 exchange, your old basis transfers to the replacement property. The IRS does not allow you to recover basis tax-free ahead of recognizing gain when boot is involved.

What Taxes Might Apply?

When a 1031 exchange is only partially completed, or if it involves boot, here are the types of taxes you may be subject to:

• §1245 Recapture: Up to 39.6%
  Applies to depreciation on personal property or components of certain mixed-use assets.

• §1250 Depreciation Recapture: Up to 25%
  Depreciation taken on real property is subject to recapture if gain is recognized by the taxpayer.

• Federal Capital Gains Tax: Up to 20%
  Applies to any appreciation not offset by basis or depreciation.

• §1411 Net Investment Income Tax: 3.8%
  This surtax applies to high-income taxpayers over a certain threshold with passive real estate income or gain.

• State and Local Taxes: Varies
  Several states and many municipalities impose their own capital gains or income taxes on real estate transactions.

Planning Is Key

Partial exchanges occur for many reasons: tight market conditions, failed inspections, financing limitations, or timing challenges. But with proper planning, the tax impact of receiving boot can be anticipated, calculated, and in some cases, mitigated.

For example:

• You may choose to receive boot in the form of a mortgage payoff or cash back at closing with full awareness of the tax it triggers.

• Alternatively, you might decide to complete a full exchange, then consider a refinance after closing in a separate transaction to access liquidity in a more tax-efficient manner.

Partial 1031 Exchanges Still Offer Beneficial Tax Deferral

A “less than perfect” 1031 exchange doesn’t eliminate all the benefits of tax deferral. Even partial deferral can improve your financial position, but you must understand how the IRS applies gain recognition when boot is involved. Remember: gain is taxed before basis is returned.

If you are considering a 1031 exchange and wondering about partial reinvestment, depreciation recapture, or the impact of boot, now is the time to consult a qualified tax advisor.

• 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.

© 2025 Copyright Jeffrey R. Peterson All Rights Reserved