SECTION 1031 INTENT
Section 1031 Intent is the most misunderstood concept in all of Real Estate Investing when using a Section 1031 Like Kind Exchange.
Because of the large amount of misinformation on blogs and real estate forums, there is a widespread belief that when you buy real property, you must also formulate in your mind, at that time, what your future intentions are regarding the disposition of the property.
It gets worse.
The “believers” further claim that if your intent was to fix up the property and sell it, then you are a Dealer, and:
* Your profit when you sell the property can never be classified as Long Term Capital Gains,
* The income when you sell the property, even ten years later, will be ordinary income,
* In addition to the income being ordinary income, it will also be subject to 15.3% self-employment tax, and
* You can never use this property as the Relinquished Property in a Section 1031 Like Kind Exchange.
All of this is totally incorrect!
If you held the investment property for at least a year and a day, when you sell it the profit is Long Term Capital Gains.
If the profit is Long Term Capital Gains, you can defer the taxes by entering into a Section 1031 Like Kind Exchange if the property was “held for productive use in a trade or business or for investment.”
1031 INTENT IS IRRELEVANT
It is completely irrelevant why you bought the property that you are selling in a Section 1031 Like Kind Exchange, assuming that you even had a definite (or even vague) idea about that at the time.
The test of whether property is held primarily for sale or for investment is applied at the time of the Exchange.
The ruling case on this issue is Cottle v. Commissioner, 89 T.C. 467 (1987) which said:
“The purpose for which a taxpayer holds property at a particular time is, of course, subject to change. But generally it is the purpose for which the property is held at the time of sale that determines tax treatment. Daugherty v. Commissioner, 78 T.C. at 629; Biedermann v. Commissioner, 68 T.C. 1, 11 (1977).”
This is easy enough to understand, but to make it even more clear, let’s do a complete analysis of the question.
If you are not familiar with any of the terms, refer to our Dictionary.
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SUMMARY: There is nothing in the Internal Revenue Code, Tax Court cases, or on IRS tax forms and/or Instructions that would support the claim that “intent” at the time of purchase of Relinquished Property is an element in a Section 1031 Exchange. In fact, there is a Revenue Ruling and two Tax Court cases that say exactly the opposite.
READING TIME: 5 minutes, 10 seconds.
INTENT IN SECTION 1031
Always start by reading the Code. It says:
(1) In General – No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. (Emphasis added).
Section 1031 continues on for more than three thousand words, including footnotes, and none of those words is “intent” and none of the sentences say anything about what was supposedly going on in your mind at the time of purchase.
So, if the question should ever come up, between you and the IRS, how would you prove that the Relinquished Property was property held for productive use in a trade or business or for investment because of something in your mind at the time that you bought it?
1031 INTENT IN REPORTING RENTAL INCOME
If your income property was rental property, and it probably was, it was reported either on your Schedule E, or on your Schedule C, of your Form 1040, if you are an individual.
Neither Schedule E nor Schedule C have a place to tell the IRS what was in your mind when you bought the property.
At the time you decide to use this property as your Relinquished Property in a Section 1031 Like Kind Exchange, you will probably have two annual tax returns showing this income property on them.
This is because you must have held it for at least a year and a day in order to qualify for Long Term Capital Gains treatment, and a year and a day will necessarily cover two tax years.
(The IRS computer system that processes tax returns does not have an internal audit program that matches Section 1031 sales to rental income reported on tax returns, but if they did, this is where they would look.)
So, maybe the question is does this imaginary “intent” have anything to do with qualifying for Long Term Capital Gains treatment?
1031 INTENT IN LONG TERM CAPITAL GAINS
Again, let’s look to the IRS. Publication 544, entitled “Sales and Other Dispositions of Assets,” which says:
“Section 1231 transactions are sales and exchanges of property held longer than 1 year and either used in a trade or business or held for the production of rents or royalties.”
Notice that it says “used” and it says “held.”
It says nothing about “intent.”
That sounds like the description of Relinquished Property in a Section 1031 Exchange transaction.
Now let’s look at Schedule D (1040), titled “Capital Gains and Losses,” where you report the sale of Section 1231 property.
Schedule D devotes Part II to “Long-Term Capital Gains and Losses – Assets Held More Than One Year.”
The only information requested on Schedule D is the purchase price, the sales price, adjustments, and amount of gain or loss.
Nowhere on Schedule D does it ask for any other information concerning the property.
And the word “intent” does not exist on the Form or in the Instructions.
Now, lets look at Section 1221.
Internal Revenue Code Section 1221, titled “Capital Asset Defined,” is the authority on whether or not an asset qualifies for Long Term Capital Gains treatment.
It contains no reference to “intent” or to anything concerning the reason that the assets was originally purchased.
That covers the Internal Revenue Code.
OK, what about Court Rulings?
1031 INTENT IN SECTION 1031 COURT CASES
Section 1031 contains no “intent” requirement regarding the purchase and holding of Relinquished Property in a Section 1031 Exchange.
So, there are no Tax Court cases that rule on the meaning.
In addition to the Cottle, Daugherty, and Biedermann cases above, the IRS position is made clear in Revenue Ruling 57-244.
The Ruling says that the taxpayer’s “purpose” for holding the Relinquished Property is a question that is determined at the time that the Exchange takes place, and not his original purpose for acquiring the property. Revenue Ruling 57-244, 1957-1 C.B. 247.
This was also the decision of the court in Gulfstream Land and Development v. Commissioner Internal Revenue, 71 T.C. 587.
In Gulfstream Land Development, the Court said that whether property is held for a proper purpose is a question of fact for the Court to determine at the time of trial, because, “…such a question is one of material fact because its resolution is necessary to a decision…”
And in Brauer v. Commissioner, 74 T.C. 1134, the Court determined that the taxpayer’s intent at the time of the Exchange regarding the Relinquished Property is controlling, and must be determined.
So, there are no Court cases resolving the question of “intent” regarding Relinquished Property because there is no such requirement regarding Relinquished Property.
There must be a statutory requirement for something in order for the Court to determine what the requirement means.
But there are Court cases on other issues where the question came up regarding the taxpayer’s “purpose” for holding the Relinquished Property.
Not “intent.” “Purpose.”
The current rule is that the “purpose” for which the property was acquired is a question of fact and one that is determined at the time of the Section 1031 Exchange.
1031 INTENT IN FORM 8824
The final step in your Section 1031 Like Kind Exchange transaction is to report the exchange on Form 8824, titled Like-Kind Exchanges.
Nowhere on this form is there any statement or question regarding the seller’s intent when he bought the property.
The IRS “Instructions for Form 8824” likewise contain no reference to “intent” nor to any reason or condition surrounding the property purchase.
There is no requirement that you formulate any “intent” when you purchase real property.
If you did form an “intent,” there is no requirement that you declare such “intent.”
If there were, there is no prescribed method for doing so.
When you sell property held for productive use in a trade or business or for investment in a Section 1031 Like Kind Exchange, whether for a Delayed Exchange, Reverse Exchange, or Construction Exchange, your “intent” when you originally purchased it, if you had any, is completely irrelevant, and there is nowhere to report it anyway.
Revenue Ruling 57-244 says that the taxpayer’s “purpose” for holding the Relinquished Property is determined when the Exchange takes place.
The five ruling Tax Court cases say that the taxpayer’s intent regarding both the Relinquished Property and the Replacement Property at the time of the Exchange is controlling, and must be determined.
Code Section 1031 says nothing about “intent” regarding the Relinquished Property.
Schedule E and Schedule C and Form 1040 say nothing about “intent.”
Code Section 1221 says nothing about “intent.”
Code Section 1231 says nothing about “intent.”
And, finally, the Form 8824 on which the Section 1031 Exchange is reported contains no question nor reference to the reason for purchasing the Relinquished Property.