Can I Still Use Section 1031 to Sell My Investment Property Even If That Was Not My Original Intent When I Bought It?

Section 1031 Intent

“Intent” is the most misunderstood concept in all of Real Estate Investing using a Section 1031 Like Kind Exchange.

Because 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.

Ridiculous? Yes.

But wait, it gets worse.

The “believers” further claim that if your intent was to fix up the property and sell it, then you are a real estate dealer, and:

• Your profit when you sell the property can never be reported as Long Term Capital Gains,
• The income when you sell the property, even ten years later, must be reported as 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 your Relinquished Property in doing a Section 1031 Exchange.

All of this is totally incorrect!

There is nothing in the Internal Revenue Code, Tax Court cases, IRS Publications, Forms, or Instructions that would support any of those claims.

In fact, there are five Tax Court cases and one Revenue Ruling that say just the opposite.

And yet, this is exactly what you will read on the blogs and real estate forums, and hear on the podcasts where the echo chambers are.

The facts?

If you held the investment property for at least a year and a day, when you sell it, the profit will be Long Term Capital Gains.

If the profit is Long Term Capital Gains, you can defer the taxes by entering into a Section 1031 Exchange if the property was “held for productive use in a trade or business or for investment.”

Intent Is Irrelevant

It is completely irrelevant why you bought the property that you are selling in a Section 1031 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 is Cottle v. Commissioner, 89 T.C. 467 (1987) which said:

The Court said, “…this purpose is determinative,” but added that the Court “…may consider earlier events to decide what the purpose was at the time of sale.”

The Court specifically rejected the IRS contention that because the taxpayer intended to sell the property after satisfying the holding period requirement for Long Term Capital Gains treatment, then the property was being held for resale and was not investment property even though the taxpayer used the property in his trade or business of renting apartments.

“Intent” in Section 1031

Always start by reading the Internal Revenue Code.

Section 1031(a) says:

The rest of Section 1031 continues on for more than 3,000 words, including footnotes, and none of those words is “intent.”

And there is not a single reference to what was going on in the mind of the purchaser at the time of purchase.

So, if the question ever came up, how would you prove that the Relinquished Property was property held for productive use in a trade or business of for investment because of something in your mind at the time you bought it?

You couldn’t.

“Intent” in Reporting Rental Income

If your investment property was rental property, and it probably was, it will have been reported either on your Schedule E, or on your Schedule C, attached to 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, and they don’t ask.

At the time you decide to sell the property and do a Section 1031 Exchange and use this property as your Relinquished Property, you will probably have two of your tax returns on which this property appears as income property.

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 and two tax returns.

So, does this imaginary “intent” have anything to do with qualifying for Long Term Capital Gains treatment?

“Intent” in Long Term Capital Gains

Again, let’s look to the IRS.

Publication 544, entitled “Sales and Other Dispositions of Assets,” says:

Notice that it says “used” and it says “held.”

It says nothing about “intent.”

And it sounds just like the description of Relinquished Property in a Section 1031 Exchange transaction.

Now let’s look at Schedule D (1040), entitled “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, let’s look at Section 1221.

Internal Revenue Code Section 1221, entitled “Capital Asset Defined,” is the authority on whether or not an asset qualifies for Long Term Capital Gains treatment.

The Section contains no reference to “intent” or to anything concerning the reason that the asset was originally purchased.

That covers the Internal Revenue Code.

OK, what about Court Rulings?

“Intent” in Section 1031 Court Cases

As I showed earlier, the language of Section 1031 contains no “intent” requirement regarding the purchase and holding of Relinquished Property in a Section 1031 Exchange.

Therefore, there is no language for the Tax Court to interpret.

Remember, the Tax Court doesn’t make law, it interprets law and applies it to the facts.

So, there are no Tax Court cases that rule on the meaning of “intent” in the statute, because the word doesn’t exist in the statute.

The Cottle, Daugherty, and Biedermann cases above clearly establish the Tax Court position on the concept of intent when it is relevant.

As for the IRS, their 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 (“used in a trade or business or held for the production of rents or royalties”) 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 question to be resolved. There is no intent requirement regarding Relinquished Property.

There must be language in the statute in order for the Court to interpret the language, and there is no language in Section 1031 regarding intent in purchasing the Relinquished Property.

But there are Court cases on other issues where the question came up regarding a taxpayer’s “purpose” for holding the Relinquished Property.

Those Court cases form the current rule that the “purpose” is a question of fact and one that is determined at the time of the Section 1031 Exchange.

“Intent” in Form 8824

The final step in your Section 1031 Exchange transaction is to report the Exchange on Form 8824, entitled “Like-Kind Exchanges.”

Nowhere on this Form is there any statement or question regarding the seller’s “intent” or “purpose” for buying the property.

The IRS “Instructions for Form 8824” likewise contains no reference to “intent” or “purpose” or to any other reason or condition surrounding the property purchase.

Conclusion

There is no requirement that you formulate any “intent” in your mind when you purchase real property.

If you did form an “intent,” there is no requirement that you declare such “intent.”

In fact, there is no prescribed method or place for doing so.

So, when you sell property held for productive use in a trade or business or for investment in a Section 1031 Exchange, your “intent” when you originally purchased it, if you had any, is completely irrelevant.

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” regarding the Relinquished Property.

Code Section 1221, “Capital Assets Defined,” says nothing about “intent” regarding the Relinquished Property.

Code Section 1231, “Property Used in a Trade or Business and Involuntary Conversions,” says nothing about “intent” regarding Relinquished Property.

Schedule D, “Capital Gains and Losses,” says nothing about “intent” regarding Relinquished Property.

IRS Publication 544, “Sales and Other Dispositions of Assets,” says nothing about “intent” regarding Relinquished Property.

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.

So, when you visit the echo chamber, take “How To Do A Section 1031 Like Kind Exchange” with you for support.

Those “experts” really believe what they are saying.