The ability to defer taxes through a 1031 Exchange can make or break a real estate transaction.  But federal tax law does not treat all real estate owners equally. Under IRC Section 1031(a)(2), real property held “primarily for sale” in the ordinary course of a trade or business is excluded from Section 1031 and may be subject to ordinary income taxes in the event of a sale.

Generally, land held for investment purposes can be swapped for “like kind” property without triggering taxable gain. However, certain property is excluded from 1031 because, under IRC Section 1221(a)(1), it is not a capital asset, including:

(i)   Stock in trade of the taxpayer
(ii)  Inventory; or
(iii) Property held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business.

Such property, including any real estate which qualifies as inventory, is excluded from 1031 treatment and, upon sale, is taxed at ordinary income rates. This means that active developers dealing in subdivided property for sale in the ordinary course of business may be excluded from capital gains tax treatment.

The key is whether the real property at issue is a capital asset or inventory. Capital assets are assets held as an investment or for productive use in a business.  Inventory or stock in trade is fundamentally different from capital assets in that it is held for the purpose of resale to customers in the ordinary course of business.

Whether real estate is a capital asset eligible for 1031 depends both on the nature of the owner’s business and the owner’s activities with respect to the property. A real estate developer marketing subdivided lots and spec homes for sale may qualify as a dealer selling inventory.  The same party holding separate land for investment without subdivision or major development may be an investor. Meanwhile, a part-time investor actively marketing property for sale may not be deemed a dealer because the activities do not constitute a trade or business. See Evans v. IRS, T.C. Memo. 2016-7 (Jan. 11, 2016).

There are no bright lines.

In the Ninth Judicial Circuit, which includes California, Washington, Oregon, Alaska, Idaho, Nevada, Arizona, and Montana, courts look to five factors to determine the nature of the taxpayer’s business and whether property is held primarily for sale to customers in the ordinary course of the taxpayer’s business:

  1. The purpose for which the property was acquired;
  2. The frequency and continuity of property sales over an extended period;
  3. The nature and extent of the taxpayer’s business;
  4. The activity of the taxpayer with respect to the property; and
  5. The extent and substantiality of the taxpayer’s transactions.

See Redwood Empire Sav. & Loan Ass’n v. Comm’r, 628 F.2d 516, 517 (9th Cir. 1980); Pool v. Comm’r, 251 F.2d 233, 237 (9th Cir. 1957); Evans, T.C. Memo. 2016-7.

The more the facts suggesting the taxpayer is in the business of selling real estate and the property was held for sale in the ordinary course, the higher the likelihood the property will be deemed inventory, excluded from like-kind exchange treatment, and, upon sale, subject to ordinary income tax rates.

IRS Safe Harbor? Don’t Bet on It

Section 1237 of the Internal Revenue Code contains a safe harbor that allows a taxpayer to sell up to five lots and pay tax at the long-term capital gains rate if certain requirements are met.  However, the requirements are burdensome. For example, the development entity must hold the property for five years, and the developer must not make any significant improvements during the holding period. This is only a partial list of requirements.  Because few developers mothball property for such long periods without development, the safe harbor may have little practical value.

Structuring to Minimize Taxes

There are no guarantees about how the IRS may view real estate sales.  However, good practice for developers holding property as investments is to place the property in an entity separate from their inventory properties. The investment property should be managed discretely consistent with its purpose as an investment. Also, an investor seeking to qualify for like-kind exchange treatment should consider limiting the amount of development and advertising activities with respect to the investment property.

Questions? Contact Ben Spiess at or Kevin Pearson at