Dealer Property does not qualify for nonrecognition of capital gains, because Section 1031 is only for property that is “held for productive use in a trade or business or for investment.”
But that does not mean that your investment property is automatically “Dealer Property” just because it doesn’t meet this definition.
In fact, that phrase, “property held for productive use in a trade or business or for investment,” is not defined by Section 1031(a)(1).
And it is not defined by the Treasury Regulations.
DEALER PROPERTY DEFINED
So, the fact is, we can’t put your specific piece of property to the Dealer Property test by using a definition.
However, the next paragraph, Section 1031(a)(2)(A) says:
(2) Exception. This subsection shall not apply to any exchange of –
(A) stock in trade or other property held primarily for sale,
(B) … (Emphasis added)
That means that these two classes of property, “stock in trade” and “other property held primarily for sale,” cannot be used as Relinquished Property or Replacement Property in a Section 1031 Like Kind Exchange.
Conversely, it impliedly means that property other than these two classes of property can be used as Relinquished Property or Replacement Property in a Section 1031 Like Kind Exchange, so long as the property has been “held for productive use in a trade or business or for investment.”
So, we just have to make sure that your property is not “stock in trade” or “other property held primarily for sale.”
Then we can see if it otherwise qualifies for a Section 1031 Exchange.
So let’s look for a definition for each of these two terms.
STOCK IN TRADE
The first one, “stock in trade,” is usually what we refer to as “Dealer Property.”
And it does have a definition.
The definition is contained in Code Section 1221(a)(1), entitled “Capital Assets Defined.”
The IRS uses this definition in its arguments before the U.S. Tax Court, and the the Court’s Judges use this definition in reaching their decisions.
Stock in Trade/Dealer Property is defined as two types of property:
1.) “property which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or
2.) “property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.”
Now note, and this distinction is critical, that this is only the definition of “stock in trade,” the first of the two excluded classes.
It is not the definition of the second excluded class, “other property held primarily for sale.”
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DEALER PROPERTY DISTINGUISHED
This Section 1221(a)(1) definition says that the property is Stock in Trade/Dealer Property if “held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.“
And the Section 1031(a)(2)(A) definition of property excluded from Section 1031 treatment says, “…or other property held primarily for sale,” but does not specify that the taxpayer is a dealer and has customers.
This is a much broader definition.
You can own investment property that is “held primarily for sale” because that is why you invested in it- to resell it.
But it is not “held primarily for sale to (your) customers in the ordinary course of (your) trade or business,” which is the Section 1221 definition of “stock in trade.”
So the two definitions are not the same.
Property described in Section 1221(a)(1) is not considered a capital asset and therefore not qualified for Capital Gains treatment and therefore not eligible for use as Relinquished Property in a Section 1031 Like Kind Exchange.
In other words, a dealer in real estate cannot use Section 1031 to defer capital gains taxes on the inventory he sells.
But the taxpayer with “other property held primarily for sale” is not classified as a dealer under Section 1221(a)(1) and his property is not classified as dealer property, although he is still excluded from using Section 1031 unless he can show that his property is not “held primarily for sale,” as that term is used in Section 1031(a)(2)(A).
And this is what all of the court cases are about.
DEALER PROPERTY COURT CASES
So let’s talk about court cases.
The first thing you must understand about court cases is that the IRS does not have to prove anything, as surprising as that might seem to you.
If you ever have a serious problem with the IRS, it will begin when the IRS determines that you owe taxes.
They will notify you with a Notice of Delinquency.
If you don’t want to pay the taxes, you have two choices:
First, you can pay the disputed taxes, hire an attorney, and sue the IRS in Federal District Court to get back what you paid.
Second, you can refuse to pay the taxes, take the IRS to the U.S. Tax Court, which is sort of a “People’s Court,” and represent yourself.
If you go to U.S. Tax Court, the IRS will explain their determinations and conclusions to the Court, and then it will be up to you to disprove them.
These determinations “are presumed to be correct, and petitioner has the burden to establish that they are erroneous.” Rule 142(a), United States Tax Court; Welch v. Helvering, 3 USTC 1164, 290 U.S. 111, 115 (1933).
And here’s what you are up against.
The Courts have already established the test for “property held primarily for sale.”
In Cottle v. Commissioner, 89 T.C. 467 (1987), the Court said:
“The test of whether property is held primarily for sale or for investment is applied at the time of the exchange.”
“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 the sale that determines tax treatment. Daugherty v. Commissioner, 78 T.C. 623; Biedermann v. Commissioner, 68 T.C. 1, 11 (1977).”
According to Cottle, “To decide whether particular property is held for sale to customers in the ordinary course of the taxpayer’s trade or business, courts have considered the following factors:
* The nature and purpose of the acquisition of the property and the duration of the ownership;
* The extent and nature of the taxpayer’s efforts to sell the property;
* The number, extent, continuity and substantiality of the sales.
* The extent of subdividing, developing, and advertising to increase sales;
* The use of a business office for the sale of the property;
* The character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and
* The time and effort the taxpayer habitually devoted to the sales.
The Court emphasized that, “The foregoing factors have no independent significance; they are merely factors to help us decide, on the basis of the record as a whole,” whether “the taxpayer held the property primarily for sale to customers in the ordinary course of his trade or business…”
Other Courts have developed similar lists of factors to be considered.
Even before the Cottle case, the Court, in Brauer v. Commissioner, 74 T.C. 1134, (1980), said:
“The taxpayer’s intent at the time of the exchange is controlling and must be determined.”
The court was reflecting a long-standing principal established in Revenue Ruling 57-244, 1957-1 C.B. 247, which said, “The taxpayer’s purpose for holding the Relinquished Property and the Replacement Property is determined when the Exchange takes place.”
This was reinforced in Gulfstream Land and Development v. Commissioner of Internal Revenue, 71 T.C. 587, 1979 WL 3690, where the court said, “Whether property is held for a proper purpose is a question of fact.”
Many of the cases that are relevent on the subject of Dealer Property also play significant roles in other Section 1031 issues, and I urge you to also read about Intent.