The other day, a good friend of mine told me he’s planning on making some improvements to a piece of land he owns. Located in a southern state known for its strong agrarian heritage, his property is essentially a big plot of open land. As such, he intends to construct several buildings and perform extensive landscape renovation.
As far as I know, this friend doesn’t have any plans to sell this plot at any point in the near future; he’s happy with his property, but the modifications he intends to make planted a few interesting thoughts in my mind. His improvements made me think of the distinction—oftentimes subtle—between investor status and dealer status in real estate transactions. Most investors pay little attention to this distinction, but the fact is, this seemingly minor detail can have a huge impact on a transaction.
In 1031 exchanges, whether a person is classified as either an “investor” or a “dealer” is a vital determination because dealer status will prevent non-recognition of capital gains under section 1031. As an investor, it’s important to be aware of the sort of behavior which will lend support to your being classified as a dealer so that you can be sure to avoid such behavior. Of course, as with plenty of other distinctions under the law, the precise boundary between investor and dealer is often difficult to pinpoint; being aware of some of the basic differentiations between investors and dealers, and knowing how to avoid dealer classifications, can make or break a good deal.
Byram and the Seven Pillars of Capital Gain Treatment
Section 1031 of the IRC is directed toward investors who are looking to exchange their (investment) property for like-kind property. And whether you qualify for investor status depends on your actions leading up to—and surrounding—the exchange. Unlike other aspects of section 1031 exchanges, the IRS has not issued specific guidelines that you and other investors can use to ensure investor status classification. But this doesn’t mean you’ll be left out in the cold: you can always look to past cases for guidance.
The case of Byram v. United States, for instance, is perfect for helping you get a sense of the boundaries between investor status and dealer status. In this famous case, the taxpayer (John D. Byram) sold a total of 22 pieces of land over a three-year period between 1971 and 1973. In the end, he grossed over $9 million and had a net profit of roughly $3.4 million. Mr. Byram argued that, even though the sales occurred over a three-year period, he should be liable only for capital gains because the pieces of land were held for investment.
In order to make an informed decision, the court took a closer look at Byram’s actions prior to the sales. During this investigation, they focused on seven factors—now known as the “seven pillars of capital gain treatment”—which they deemed critical for determining a classification:
- The original purpose of the acquisition and the duration of ownership
- The nature and extent of the efforts to sell the property
- The number, extent, continuity and overall size of the sales
- The time and effort expended to developing the land and the advertising to increase sales volume
- Use of a business office
- The degree of supervision exercised by the owner over any person hired to sell the property
- The total time and energy devoted to the sales
Of course, these seven factors are not exhaustive, and courts may take other elements into consideration on a case-by-case basis. In fact, many of today’s experts now use a nine-point system for sorting between dealer status and investor status, adding two more points:
- Was the property listed with a real estate broker or another outlet?
- The purpose of the property at the time of sale
All of these factors give you some indication of the difference between dealer and investor for legal purposes. As an investor, you want to use this information and tailor your actions to minimize your chances of being classified as a dealer.
The Byram case contributed substantially toward a practical definition of an “investor” under the law. And in a 1031 exchange, you will be subject to the same sort of analysis that took place in Byram if your actions call into question your status as an investor. Remember, in a 1031 exchange you’re deferring capital gains, not ordinary income, so your investor status means that you’ll trigger capital gains in the event of a sale.
Monitor Your Actions Prior to Your 1031 Exchange
Carefully monitoring your actions before you initiate your 1031 exchange transaction is vital to avoiding dealer classification and losing your chance at receiving section 1031 treatment. If you’ve already taken certain actions which may trigger that classification, however, don’t panic just yet—remember that the court always takes the big picture into account before making a decision. In the Byram case, Mr. Byram did certain things which seemed to suggest that he was a dealer, but the court granted him investor status anyway because they made their assessment based on the totality of his actions.
CWS Capital Partners has substantial experience with like-kind 1031 exchanges and would be more than delighted to walk you through the process.
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