Author: Matthew Riley
How do you characterize vacant and unproductive land that is not used for personal enjoyment nor in furtherance of any trade or business purpose?
As we described in a prior article, for property to qualify for a Like-Kind Exchange the real estate investor must hold it for productive use in a trade or business, or for investment purposes. But what about property that is unproductive, meaning that it does not provide any profitable income to the owner, or that perhaps even creates losses for them? What about acquired property that an owner has left untouched or unimproved?
Treasury Regulation 1.1031(a)-1(b) explains that “Like-Kind” refers to the “nature of character of the property and not to its grade or quality.” The regulation further states that “[o]ne kind or class or property may not, under [Section 1031], be exchanged for property of a different kind or class.”
IRS Publication 544 outlines different kinds or classes of property eligible for like-kind exchanges. Real estate is one kind or class of property, but other property classes exist. The IRS, for example, has created general asset classes for personal property– some of these include the following:
- Asset Class 00.12 – Information systems, such as computers and peripheral equipment.
- Asset Class 00.21 – Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or friend, and all helicopters (airframes and engines).
- Asset Class 00.23 – Buses
What Treasury Regulation 1.1031(a)-1(b) does is restrict property exchanges between any two different and distinct classes– an office building considered to be in the real estate class cannot be exchange for a Learjet 85, considered to be in the airplane class or asset class 00.21; The IBM Sequoia supercomputer in the asset class 00.12 cannot be exchanged for a Justin Bieber Tour Bus in the asset class 00.23.
In other words, the IRS is talking about apples and oranges. Apples can be exchanged for any other apple because they are the same kind of fruit. But you cannot exchange an apple for an orange, because these are two different types or classes of fruit. But again, any apple can be exchanged for any other apple. A Red Delicious apple can be exchanged for a Granny Smith or Fiji; a rotten apple on the ground can be exchanged for one picked from the apple tree. The reason this analogy works is because the exchange is occurring within the general class of apples, and the differences that exist are due to the variety of types and qualities existing between any two apples within that class.
Under the general and broad property class, “real estate”, there are countless types and qualities of real estate. The IRS is not concerned with the peculiar qualities of the properties being exchanged, whether the property is a warehouse or pasture, profitable or not to the owner, they are only looking to see whether the properties are both classified as real estate. Whether the land is vacant or unproductive, therefore, is not material to whether the property is eligible for an exchange.
There are, however, two important caveats to this general rule:
1 – In nearly all cases, real property located in the United States in not like-kind to property located outside the United States. Therefore, an investor cannot use the 1031 Exchange rules where he sells a parking lot in San Diego, California, to buy an office building in Toronto, Canada.
2 – Unproductive real estate held by a dealer is not eligible for a Like-Kind Exchange. A dealer of real estate is one that holds such property in inventory for resell. But this does not necessarily mean that all property held by a dealer is ineligible for exchange. Dealers may hold investment property that would qualify for an exchange. Case law makes clear that a person may be both a dealer and an investor; this is because what matters in a like-kind exchange is not an individual’s characteristics, but rather the characteristics of each parcel of property. See William B Howell, 57 T.C. 546, 557 (1972); Real Estate Corp., 35 T.C. 610 (1961).
Again, there is no bright-line rule between a dealer and investor under Section 1031, it all depends on the dealer’s relationship to a particular parcel of property. Whether the IRS will consider a dealer an investor and thereby eligible for a particular property exchange is a question of fact. The tax courts have adopted several tests it applies when considering this question, including:
- The purpose for which the asset was acquired;
- The frequency, continuity, and size of the sales;
- The activities of the seller in the improvement and disposition of the property;
- The extent of the improvements made to the property;
- The proximity of sale to purchase; and
- The purpose for which the property was held during the taxable years.
See Harbour Properties, Inc v. C.I.R., 32 T.C. 580 (1973), citing Howell, 57 T.C, at 546.
In Harbor Properties, Mr. Gould, a dealer in land, had acquired 160 acres of land from the Clin Clara Company. For a little over 5 years, he held the land as unproductive, taking no steps to develop or improve the property or list it for sale. Then in 1959, Mr. Shore, a person unrelated to Mr .Gould, offered to purchase a portion of the Clin Clara property. Mr. Gould accepted the offer and conveyed 137—half-acre portions of the 160 acres he originally acquired.
In considering whether Mr. Gould was a dealer or investor, the court considered facts intimating Mr. Gould’s relationship to the Clin Clara property. Applying the tests above—the court determined that Mr. Gould held the Clin Clara property as an investment. The court highlighted that “[d]uring the period between acquisition and disposition the land was neither subdivided nor improved. Gould did not advertise the property for sale but rather was approached with regard to its sale.” Id. From these facts– the court determined Mr. Gould was an investor in the property and such property was eligible for an exchange.
If you are a real estate “dealer” attempting to execute a Like-Kind Exchange, you should consult an attorney to confirm that for the Exchange you are a properly designated real estate investor under the tax laws.
Below is the Table of Contents for the 1031 Exchange Series of Articles.
PART 1 – THE RELINQUISHED PROPERTY (SOLD PROPERTY) MUST HAVE BEEN HELD BY THE EXCHANGER FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMEST PURPOSES.
PART 2 – THE EXCHANGER MUST INTEND TO HOLD THE REPLACEMENT PROPERTY (ACQUIRED PROPERTY) FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMENT PURPOSES.
PART 3 – BOTH THE RELINQUISHED AND REPLACEMENT PROPERTY MUST HAVE A NATURE AND CHARACTER THAT IS “LIKE-KIND” WITH THE OTHER.