Determining Dealer Status in a 1031 Exchange

David Moore: Hello, David Moore With Equity Advantage, 1031Exchange.com. We’ve got a sister company, IRA Advantage, iraadvantage.com, that handles self-directed retirement accounts. Today we’re going to talk about dealer status on investment properties, and we’re going to talk about that for a variety of reasons.

One of them is COVID. Okay? And the reason COVID impacts this is, we’ve got many people in a variety of places throughout the country that have tenants that are being told they don’t have to make any payments to them. And just this morning actually, Biden Administration extended that sort of a rent-free or rent-deferral period into March, which from my perspective is just going to be very, very, very tough on taxpayers.

The property owners, nobody’s telling the banks to sit back. You know, for some reason the tenants are getting this relief. But who’s going to tell the banks to sit back on the property owners? So imagine if the property owner has a bunch of units and they can’t afford to cover the debt service on it, the tenants are being told they don’t have to pay, they end up losing the property. And I guess the worst case in that situation is you could have a phantom gain situation, which is another seminar. Or not another seminar, another news segment, newsletter segment and video that we’ll be doing. But if we look at things, when you look at holding periods, there’s lots of misinformation out there in Section 1031.

David Moore: I hear two years all the time. Yesterday, I heard somebody saying their CPA said it had to be three years. There’s no stated hold period in Section 1031. So what we have to look at is not the hold period, it’s what the person’s done, what they do for a living. So what we do is, look at the old Klarkowski court case, nine points used to determine dealer status. I actually use those nine points when we’re looking at our retirement account clients too. You might be saying, “Well, why would it impact a retirement account?” Well, how it does impact it is, is if we’re looking at an investment property versus a business property.

So for example, if we’re looking in the IRA 401(k) world, we’ve got a client that’s got a multifamily project. That multifamily project has a laundromat in it. Well, that laundromat’s one component of the investment. You’ve got an investment there. Now the taxpayer says, “Gee, I really like the laundromat,” so they want to take their retirement account and go buy a new laundromat. Well, now they’ve bought a business. So even with a Roth IRA, you’re going to have something called unrelated business taxable income, a UBIT or UBTI. And that’s going to be something that triggers tax exposure for somebody in a retirement account if they’re doing business versus investing.

David Moore: Now those same issues, when we apply them to 1031, are used to determine dealer status. So you can be a dealer and still have investment property and property held for resale. Now, what’s the difference between those two things? Well, property held for resale, one, doesn’t receive long-term capital gains tax treatment. Two, does not fit section 1031, where investment property does. The hold period, one year’s been proposed several times, and if you look at the break between short and long-term on assets held for investment, that falls at one year. So I think there’s several reasons to point at one year as a suggested hold. But really it has to do with intent. Anything beyond one year, the two-year hold I believe is just something that’s misinformation out there. I think people look at Section 1031 on a related party transaction. The code says there’s a required two-year hold.

But honestly, even in the fine print of 1031 with related parties it says, “Well, the two years don’t apply in a related party transaction if you can document there is no intent to avoid tax. So even with a related party transaction, it’s not a black and white absolute two years, so really it’s what’s happened. What your intent was when you bought the property.

There’s a court case out there, the Reesink case, where I believe four months was the timeline. People bought a property via 1031. Documented showings. Documented the listings. Actually moved into the property. After four months argued they couldn’t afford to hold both their home and this new property. Since they couldn’t rent it out, they moved into it. They got audited, taken to court, and prevailed in court after four months.

David Moore: That’s not something I’m comfortable with, especially with that set of circumstances in that case. But if we’re looking at normal dealer status issues, we’re going to look at these nine points. One, the purpose for which the property’s acquired. Two, the purpose for which the property is subsequently held. Three, the extent of improvements made. Four, the frequency, number, and continuity of sales. Five, the extent and nature of transaction in the property. Six, the general business activities of the taxpayer. Seven, the extent of advertising and promotion of the property for sale. Eight, whether the property is listed with a real estate broker or other outlets. Nine, the purpose for which the property is held at the time of sale, as opposed to the time of acquisition.

Now think of the fact that you might be one of these people. You bought a property let’s say in a community. Let’s say it’s Portland for example. Well, property owners have very few ownership rights in the property here. You’ve got tenant rights that rule. Let’s say you bought a property pre-COVID and now the tenants haven’t been paying. You can’t afford to keep it. Could you sell that property? Even if you haven’t held it for a year, could you Exchange out of that property once again? I’m going to tell you, yes. I’m going to want you to talk to your tax people, but your intent was to do one thing, and circumstances have totally dictated a course of action.

David Moore: Now, even Section 121, the universal exclusion on home sale, it’s not an elective deal. You can’t say, “Okay. I’ve held the property for one year. Instead of getting 250 and 500, I’m going to get one 125 and 250 out of it. So it’s not an elective proration of those amounts based upon the time you hold it. But in a hardship for sale, some uncontrollable job change, economic hardship, something else out there, you are allowed a proration of 121’s 250 or 500 in a hardship situation. So once again, you’re looking at a hold period is what it says, what is or is not possible. And in 1031, you’re really looking at what that intent was when you bought the property.

Now as I said, there’s a court case where four months was deemed long enough. There’s another court case where five years was deemed not long enough. Well, why wouldn’t five years be long enough as far as a hold? Well, the reason was, is the people bought the property, immediately put it back on the market. They never held it for investment. It was held for resale the entire time they owned it. It just took five years to sell. If you’re a builder-developer, you’re going to be looked at differently than some doctor dabbling in real estate. So what was the nature of the investment when you bought that thing? What happened to it during the time you owned it?

David Moore: I’m going to tell you, don’t buy a property. Buy it, improve it, immediately put it on the market. Even if that takes six months or a year to improve the thing to prep it for market. Don’t do that. Complete it. Then you’re going to hold it, season it for a period of time. Then you will relinquish it via 1031. But in that situation you’re looking at what I believe the government’s true intent with holding periods is, they don’t want people conducting business. We all hear the ads and see the ads on TV for people flipping properties.

Well, flipping property does not fit 1031, and that’s why I’m such a proponent. I was taught 30 plus years ago, never to flip properties. My flips were not flips. We’d buy a property, improve it. We would then refi it, pulling money out, the equity out, rent it out for a couple years, and then we’d do an Exchange.

And the money via the refi typically exceeded what we would have netted after paying taxes at normal income tax rates. So anybody that’s flipping properties, they’re going to get tired of it. And I get a kick out of it. I think I heard somebody, “Oh, the BRRRR method,” like it’s some new thing. It’s been done forever. You’re not buying, repair, renew, rent, repeat. I mean, come on. People have been doing this for decades. It’s the latest acronym that we all love or hate. But the bottom line is, understand what you’re doing. The strategy that they’re employing with that acronym it makes sense.

David Moore: They forget the Exchange at the end of the day though. Because everything’s going to outlive its usefulness over time. I mean there are definitely arguments never to sell a great piece of property. But typically we’re buying things. We’re going to maximize the value. At some point, you’re going to either do a cash-out refi, and leverage out of it doing that, or you’re going to do an Exchange. The decision between the refi and the Exchange is going to be driven by whether you can do anything else to maximize the yield on that investment. But what we’re looking at is elimination of a dealer status issue.

So once again, time is not the operative issue. It’s intent, what you’re doing with the property during the time you’re doing it. What you do for a living does certainly come into it, and the government just doesn’t want this tax privileged money being able to defer everything via 1031 and competing unfairly with people that are actually in the business of doing this stuff. So if you’re conducting business, if you’ve got a company that does for a living, you’re flipping properties, it’s not going to qualify for 1031. If you’re somebody that dabbles in real estate, you bought something, you fixed it up, and your intent is to rent it out and then circumstances dictated a different course of action, I’m going to tell you it’s possible to do the Exchange.

David Moore: And there really is no stated required hold in the code. You just want your tax people to be on your page. You want to make sure that they’re agreeing with what’s going on. That’s why I tell you, talk to them before you ever sell anything, before you ever put anything on the market. Don’t talk to them simply giving them information tax return time where they have no ability to help you out. Once again, David Moore, Equity Advantage, 1031Exchange.com. If you’ve got further questions on this or any other topic, please don’t hesitate to reach out to us dmoore@1031Exchange.com or info@1031Exchange.com. Look forward to hearing from you, and have a better new year. Take care. Bye-bye.