Like Kind Exchanges Under I.R.C.

Section 1031:  Developer Issues

offered at the 1996 ICSC Law Conference by

Louis J. Rogers[1]

Hirschler Fleischer

701 East Byrd Street

Richmond, VA 23219

P.O. Box 500

Richmond, VA  23204-0500

(804) 771-9567

I.          Introduction to I.R.C. § 1031.  Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”), provides an exception to the general rule requiring the current recognition of gain or loss realized upon the sale or exchange of property.  Under Section 1031(a), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchange solely for property of a like kind (“1031 property” or “1031 properties”) to be held either for productive use in a trade or business or for investment.  The realized gain is deferred until the 1031 properties are disposed of in a subsequent taxable transaction.

II.         Excluded Property.  Section 1031(a)(2) describes several types of property which cannot be transferred or received in a 1031 exchange, including “stock in trade or other property held primarily for sale” (sometimes called “dealer property”).  This outline describes the tests used to determine if property constitutes “dealer property” and whether (and the extent to which) dealer property may be transferred or received in a 1031 exchange.

A.        Stock in Trade.  “Stock in trade” does not qualify as 1031 exchange property.  See I.R.C. § 1031(a)(2)(A).  The term “stock in trade” describes property that would be included within the inventory of a dealer of that type of property.  See I.R.C. § 1221(1).

B.         Other Property Held Primarily for Sale.  “Other property held primarily for sale” also does not qualify as 1031 exchange property.  See I.R.C. § 1031(a)(2)(A).  The characterization of property as being “held primarily for sale” is a question of fact.  The term “primarily” has been construed to mean “principally” or “of first importance.”  See Malat v. Riddell, 383 U.S. 569 (1996); Land Dynamics v. Commissioner, 37 T.C.M. 1119 (1978).

C.        Characterization of “Dealer” Property.  There is very little statutory or judicial guidance on the meaning of the phrases “stock in trade” or “other property held primarily for sale” under Section 1031.  Therefore, the analysis often must be made by analogy to the similar definition of a “capital asset” under Sections 1221(1) and 1231(b)(1).  Section 1221 provides that “the term ‘capital asset’ means property held by the taxpayer … but does not include – ( 1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business ...”  To qualify for favorable capital gain treatment, an asset must qualify as a capital asset.  Property that constitutes a capital asset generally will not constitute disqualified dealer property under Section 1031(a)(2)(A).  There are material differences between Section 1031(a)(2)(A) and Section 1221(1) – namely, that Section 1031(a)(2)(A) omits the phrase “to customers in the ordinary course of his trade or business.”  It is not known whether this was intended to be a substantive difference.  In any event, the courts frequently have considered by analogy in exchange cases authorities on the definition of a capital asset in determining whether property constitutes dealer property and, thus, not qualifying 1031 property.

III.       Primary Factors in Characterization of Dealer Property.  It may be difficult to determine why a particular parcel of real estate is held by the taxpayer.  The mere fact that the taxpayer is a “dealer” with respect to a given property will not automatically disqualify the taxpayer from effecting a qualifying exchange of other property.  However, to qualify for exchange treatment, a dealer must prove that the property in question (i) is held for investment or use in a trade or business and (ii) is not held primarily for sale.  See Land Dynamics v. Commissioner, supra; Rev. Rul. 75-538, supra; Treas. Reg. § 1.1236-1.  This is true of both the relinquished property and the replacement property in an exchange.

            The taxpayer’s historical reasons for holding property is not necessarily controlling.  Rather, it is the taxpayer’s intent at the time of the 1031 exchange which frequently will be controlling.  See, for example, Mauldin v. Commissioner, 195 F.2d 714 (10^th Cir. 1952) and Kaltrader v. Commissioner, 255 F.2d 833 (3^rd Cir. 1958), as summarized below.

            Several courts have recognized that sellers may take steps to improve their property to make it more readily acceptable without becoming a dealer.  See, for example, Ayling v. Commissioner, 32 T.C. 704 (1959).  Clearly, a developer may acquire real estate as an investment.  See, for example, Municipal Bond Corporation v. Commissioner, 382 F.2d 184, 188 (8^th Cir. 1967) and Scheuber v. Commissioner, 371 F.2d 996, 998 (7^th Cir. 1967).  Also, the taxpayer’s purpose for holding property may vary with respect to different tracts and each transaction should be examined and considered independently.  See Municipal Bond Corporation, supra.  Corporations are treated as separate entities from their shareholders, barring a piercing of the corporate veil.  Id.  Thus, a corporation may hold property for investment while the shareholder and affiliated corporations hold their property for sale.  Also, the operations of related corporations generally have no probative force in establishing the taxpayer’s purpose in holding property, barring an express or implied agency among the corporations.  Id.

            Several factors are relevant in determining whether property is held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business within the meaning of Section 1221(1).  However, no single factor is conclusive and each case is decided based on its own unique facts.  The factors described below are used by the courts as an aid in determining whether capital gain treatment is appropriate, and no one factor or combination of factors is necessarily controlling.  Thompson v. Commissioner, 322 F.2d 122 (5^th Cir. 1963).  For example, the Fifth Circuit has stated:

If a client asks in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be “I don’t know, and no one else in town can tell you.”  The difficulty, however, is inherent in the nature of the thing itself, and does not lie in judicial perversity or a delight in being obscure.  Results cannot be casually predictable where so many variables are present and so many factors of judgment must be exerted.  Extreme cases will be clear, but those who elect to sail close to the wind must take their chances.

            Biedenharn Realty Company, Inc. v. United States, 509 F.2d 171 (5^th Cir. 1975).

            The courts have developed the following factors:

A.        Nature and Purpose of the Acquisition.  The courts have frequently considered the nature and purpose of the acquisition.  The case law is summarized below.

1.         Ayling v. Commissioner, 32 T.C. 704 (1959).

a.         Taxpayer purchased a home with an adjacent extra lot because seller would only sell them together.  Taxpayer had no real estate dealings before the purchase, except the sale of a former residence and two inherited lots.

b.         Taxpayer wanted to dispose of the extra lot.  Taxpayer subdivided the extra lot into 13 lots.  No broker was involved and there was very little sales activity.  Taxpayer did not advertise the property as a subdivision and the only advertisement was the running of a few classified ads of 2 or 3 lines in the newspaper on about 12 occasions.  Taxpayer sold all 13 lots in about 4 years.

c.         The court found that the purpose behind the purchase of the lot was important.  Here, taxpayer acquired the extra lot to protect their home and not to embark on a business venture.  The taxpayer had no intent to deal in property.  Therefore, the lots constituted a capital asset that qualified for capital gain treatment.

2.         Smith v. Dunn, 224 F.2d 353 (5^th Cir. 1955).

a.         Taxpayer inherited real estate.

b.         To help promote sale of the real estate, taxpayer subdivided the real estate into lots.

c.         Taxpayer had no experience in the real estate business and engaged a broker to sell the real estate.

d.         The court held that the real estate qualified for capital gain treatment because taxpayer had not purchased the real estate for the purpose of selling lots.

3.         Biedenharn Realty Company, Inc. v. U.S., 509 F.2d 171 (5^th Cir. 1975).

a.         Taxpayer acquired a farm for investment.

b.         Taxpayer used the farm for 25 years.

c.         After the farm had appreciated significantly, taxpayer subdivided and sold half of the acreage.

d.         Taxpayer laid out and paved streets, added curbs, sewers and utilities.

e.         The court found that the property was a capital asset.

4.         Graves v. Commissioner, 867 F.2d 199 (4^th Cir. 1989).

a.         Taxpayer purchased four parcels of land.

b.         Taxpayer subdivided three parcels and left the fourth parcel undeveloped.

c.         Taxpayer contended that the undeveloped parcel should qualify for capital gain treatment.

d.         The court held that all four parcels were part of the same development.  As such, none of the parcels qualified as a capital asset and the gain on sale was ordinary income.

5.         Gartrell v. U.S., 619 F.2d 1150 (6^th Cir. 1980).

a.         Taxpayer bought property to provide investment income after retirement.

b.         Taxpayer started selling slowly, leading up to retirement.

c.         More than 40% of the income from sales was earned in the three years after retirement and not in the 17 years of ownership prior to retirement.

d.         The court found taxpayer’s purpose in acquiring the property was to hold for investment.  Therefore, the property qualified for capital gain treatment.

6.         Kaltreider v. Commissioner, 255 F.2d 833 (3^rd Cir. 1958).

a.         Taxpayers bought property to live on and to farm.

b.         10 years later, taxpayers formed a corporation to build and construct homes on a portion of the farm.

c.         Taxpayers developed seven acres of the 27-acre farm and subdivided and constructed homes on many of them.

d.         The court found that while the initial purpose might have been to hold for investment, subsequent changes led to ordinary income treatment.

7.         Turner v. Commissioner, 540 F.2d 1249 (4^th Cir. 1976).

a.         Taxpayer acquired a large farm, which it held for more than 4 years during which time it was used exclusively for agricultural purposes.  Taxpayer did not develop the farm or offer it for sale.  The farm ultimately was sold in one isolated bulk sale.

b.         Taxpayer often purchased properties and sold them to a related company for development.  Normally this would result in ordinary income.  In this case, however, the purchase was for investment in land that would not be developed for many years.

c.         Because the court found that the intent was to hold for investment, the land qualified for capital gain treatment.  The court held that even a real estate developer may acquire parcels of land for appreciation as long-term investments and qualify for capital gain treatment.

8.         Margolis v. Commissioner, 339 F.2d 537 (9^th Cir. 1964).

            [1031 Exchange Case]

a.         When taxpayer is a dealer in real estate, the burden is on taxpayer to prove that the property is being held for investment and not primarily for sale.

b.         The mere fact that a dealer holds the property for a substantial period of time for appreciation does not necessarily make it an investment property.  If the purpose of the acquisition and holding is to sell, the acquisition and holding by a dealer will be considered to have been for sale.

c.         Income-producing dealer property that is not being sold immediately may qualify for an exchange and capital gain treatment.

9.         Maudlin v. Commissioner, 195 F.2d 714 (10^th Cir. 1952).

a.         In 1921, taxpayer purchased property to engage in the cattle business.

b.         In 1924, when the cattle business became unprofitable due to drought and crop failures, taxpayer tried to sell the property, even at a loss, but was unable to do so.  Taxpayer listed the property with real estate agents and actively prompted the sale.  Beginning in 1924, taxpayer began to subdivide to help promote sales and created over 350 lots.

c.         From 1940-1945, taxpayer sold most of the lots.

d.         The court held that taxpayer’s purpose changed from the time of initial purchase (use in cattle business) to sale of the property in the ordinary course of business (dealer property).

e.         The court stated in dictum that a dealer may discontinue a real estate business and sell off the remnants of its holdings so as to qualify for capital gain treatment.

B.         Extent and Nature of Taxpayer’s Efforts to Sell.  Another important factor may be the extent and nature of the taxpayer’s efforts to sell.  The case law is summarized below.

1.         Suburban Realty Co v. U.S., 615 F.2d 171 (5^th Cir. 1980).

a.         The court determined that advertising and soliciting sales were important factors in the finding that numerous sales over an extended period of time constituted ordinary income.

2.         Smith v. Dunn, supra.

a.         The court held that hiring a broker and an engineer, putting in additional roads and allowing broker to advertise did not result in ordinary income treatment.  The court believed that, by hiring a broker and engineer, taxpayer was behaving as an investor.

3.         Ayling v. Commissioner, supra.

a.         The court recognized that no broker or salesman was used in the sale of property.  The lack of assistance in sales was important because it indicated a diminished extent and nature of efforts to sell.

4.         Biedenharn Realty Company, Inc. v. U.S., supra.

a.         Independent agents worked on commission, handled all advertising and merchandising costs.  The court affirmed capital gain treatment.

5.         Pointer v. Commissioner, 419 F.2d 213 (9^th Cir. 1969).

a.         Taxpayers began to subdivide property.

b.         Taxpayers brought in builders to build homes.

c.         Taxpayers never transferred property until homes were built and sold.

d.         Builders advertised and constructed homes.

e.         The court found that builders were acting for taxpayers.  Hence, taxpayers were denied capital gain treatment.

C.        Number, Extent and Continuity of Sales.

1.         Suburban Realty Co. v. U.S., supra.

a.         The frequency and substantiality of sales is most important.

b.         Taxpayer sold 244 properties worth $2.3 million over 33 years.

c.         83% of taxpayer’s income was from sales of properties.

d.         The court found that the property in question was not a capital asset.

2.         Wibbelsman v. Commissioner, 12 T.C. 1022 (1949).

a.         7 lot sales in taxable year were substantial.

3.         Fahs v. Crawford, 161 F.2d 315 (5^th Cir. 1947).

a.         95 sales in 2 years were not substantial.

4.         Dunlap v. Oldham Lumber, 178 F.2d 781 (5^th Cir. 1950).

a.         One or two sales over a period of 5 years were not substantial.

b.         Here, however, the IRS contended that the sales were not substantial to characterize a loss as a capital loss rather than an ordinary loss.

5.         Koch v. U.S., 457 F.2d 230 (7^th Cir. 1972).

a.         Taxpayer sold 240 lots in 6 years.

b.         Taxpayer had purchased a total of 2,700 lots.

c.         Taxpayer did not want to sell, usually only sold if there was an extreme profit or under threat of condemnation.

d.         The court stated that merely being a large investor does not necessarily turn one into a dealer selling lots in the ordinary course of business.

e.         The court affirmed a jury decision which found that only in the year of the largest number of transactions was the taxpayer a dealer, in the other years, taxpayer was an investor.

5.         Tibbals v. U.S., 362 F.2d 266 (U.S. Ct. Claims 1966).

a.         Taxpayer had real estate development experience.

b.         Taxpayer purchased 436 lots.

c.         Taxpayer subdivided and sold 102 lots individually.

d.         Taxpayer sold the remaining 334 lots as a group.

e.         The court found that sale of the 102 lots was in the ordinary course of business.

f.          The court found that sale of the 334 lots qualified for capital gain treatment.

D.        Extent of Subdividing, Developing and Advertising

1.         Smith v. Dunn, 224 F.2d 353 (5^th Cir. 1955).

a.         Taxpayer, an architect, inherited property.

b.         The property was undeveloped, with two roads running through it.

c.         When taxpayer decided to liquidate, taxpayer subdivided the property.

d.         Taxpayer hired a broker and an engineer.

e.         Taxpayer sold property adjacent to existing roads and then added additional roads and made more sales.

f.          The court found that the use of a broker suggested that taxpayer was an investor.  According to the court, developers in the ordinary course of business do not need to hire brokers to assist them.  Here, a broker had complete control over the selling process.

g.         The court held that the property was a capital asset.

2.         Fahs v. Crawford, supra.

a.         Taxpayer subdivided, replatted and extended water mains.

b.         The court looked to the purpose of the improvements, which in this case was to make the property saleable to FHA customers.

c.         The court stated that merely disposing of investment assets at intermittent intervals is not engaging in a business.

3.         Mathews v. Commissioner, 315 F.2d 101 (6^th Cir. 1963).

a.         Physician purchases numerous parcels of land over a long period of time.

b.         Taxpayer constantly sold and purchased property.

c.         Taxpayer often sold property just after the required six month holding period for capital gain treatment (under former law).

d.         The court found that the sale was in the ordinary course of business.

4.         Tibbals v. U.S., supra.

a.         Taxpayer subdivides 102 lots.  The lots were held to be ordinary income property.

E.         Time and Effort of the Taxpayer Devoted to Sales Process.

1.         Gamble v. Commissioner, 242 F.2d 586 (5^th Cir. 1957).

a.         Taxpayer, a lawyer, sold properties.

b.         The court looked at the amount of income earned as a lawyer and selling properties.

c.         The court found that when profit from sales exceeded income from one’s livelihood, ordinary income treatment is more likely.

2.         Winthrop v. U.S., supra.

a.         Taxpayer sold 456 properties over a period of time.

b.         Taxpayer was not engaged in any other line of work.

c.         The court found that income was ordinary.

3.         Biedenharn Realty Co., Inc. v. U.S., supra

a.         Gains from numerous lots were only 11% of taxpayer’s gross income.  Held, the lots were a capital asset.

4.         Mathews v. Commissioner, supra.

a.         Physician worked full-time as a doctor.

b.         Physician was on numerous committees and medical groups.

c.         In 1955 and 1956, physician earned $350,000 in real estate and $88,000 as a physician and miscellaneous activities.

d.         The court found that physician was in the business of real estate despite not having a real estate brokers license or spending much time working on real estate.

5.         Gartrell v. U.S., supra.

a.         Taxpayers earned income from working for the Tennessee Valley Authority.

b.         Amount of sales income was between 0% and 23% of annual income.

c.         Annual average was 8.5% of annual income accounted for by sales of lots.

d.         The court found that the property was not held in ordinary course of business and qualified for capital gain treatment.

6.         Mauldin v. Commissioner, supra.

a.         Taxpayer originally was a cattle farmer.

b.         Taxpayer quit cattle business and began selling the land.

c.         Taxpayer subdivided and sold 350 lots.

d.         Sales of lots was taxpayer’s only income.  Hence, the court found ordinary income treatment.