Developer or Builder Retiring: Which Projects Can Go Into a 1031

The same words exclude inventory from both capital gain and the exchange, so the test is one test

Section 1031(a)(2) says the nonrecognition rule does not apply to any exchange of real property held primarily for sale. Section 1221(a)(1) removes from the definition of a capital asset property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. A builder who fails one test usually fails the other, and the result is ordinary income with no deferral.

The Supreme Court fixed the key word in Malat v. Riddell, 383 U.S. 569 (1966): as used in section 1221, primarily means of first importance or principally. Property can be held with two purposes, and the question is which one came first for that property.

The regulations supply the mirror image. Reg. section 1.1031(a)-1(b) states that unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale, and that improved and unimproved real estate are of like kind. The gap between those two sentences is where a retiring builder's portfolio sits.

Dealer status is decided asset by asset, which is why your rentals are not tainted by your spec homes

Being in the construction business does not make every parcel you own inventory. In Maddux Construction Co. v. Commissioner, 54 T.C. 1278 (1970), the Tax Court's sole issue was whether a single tract sold by a construction company was property held primarily for sale, and it treated that as a question about the company's purpose for that tract rather than about its trade. The courts weigh the purpose of acquisition, the frequency and substantiality of sales, the improvements made, the sales effort, and the holding period, and the frequency and substantiality of sales carries the most weight.

Applied to a builder's holdings, the pattern is usually clear. Spec houses, model homes and platted lots were acquired to sell and were sold in the ordinary course: inventory. An apartment community you built, placed on a long-term loan, leased up and operated for years was held to produce rent: investment, even if you always expected to sell it eventually. Raw land bought for a future phase that never happened is the hard case, and its answer depends on what you did with it after the plan changed.

The glossary entry on dealer property sets out the factors in full, and are you a dealer, how the IRS decides covers the audit side. On a large tract sale to another developer, developer sale of land or lots covers section 1237 and the staged-closing traps.

Evidence that a project was held for investment, assembled before the listing, not after

Because the test is purpose and conduct, the record you kept while you owned the property decides it. The items below are the ones that distinguish a held project from inventory in a builder's hands; none is conclusive alone, and your CPA or tax counsel should classify each asset in writing before contracts are signed.

• Entity separation: the project held in its own LLC or in your name, apart from the development or construction company that holds inventory.
• Books and returns: the asset carried as a rental on Schedule E or Form 8825, depreciated, with no cost-of-sales treatment and no inclusion in work-in-progress.
• Financing: a permanent loan rather than a construction or revolving line, refinanced on the strength of rents.
• Operations: leases, a property manager, capital improvements made for tenants rather than for a sale, and years of rent before any marketing.
• Sales history: one sale of the whole project, not lot-by-lot or unit-by-unit sales with a sales office or advertising.
• A change of purpose, if there was one, documented when it happened: minutes, a loan application, an insurance change, a tax return that started treating the asset as a rental.

Hypothetical: three assets, two answers, and the installment trap on the third

Round, hypothetical figures for a builder retiring at sixty-eight. Asset one: eight finished spec homes worth $4,000,000 with $3,200,000 of cost. Asset two: a 60-unit apartment community you built eleven years ago, held in its own LLC, worth $12,000,000 with a $5,000,000 adjusted basis and a $6,000,000 loan. Asset three: 40 acres of entitled land bought for a phase you cancelled in 2020, worth $3,000,000 with a $1,500,000 basis, sitting idle since.

Asset one is inventory. The $800,000 of profit is ordinary income in the year of sale, cannot be exchanged, and under section 453(b)(2) cannot be reported on the installment method, because section 453(l) defines a dealer disposition to include real property held for sale to customers in the ordinary course. Asset two is investment property: $12,000,000 exchanged through a qualified intermediary into $6,000,000 of equity and $6,000,000 of replacement debt defers the entire $7,000,000 gain, including the depreciation layer.

Asset three is the one to settle with counsel. Idle land held by someone other than a dealer for future appreciation is investment property under the regulation, but land entitled by you for a project you intended to build and sell started life closer to inventory, and the question is whether your purpose changed in 2020 and whether the record shows it. If it is investment, the $1,500,000 gain exchanges; if it is inventory, it is ordinary income with no deferral. Have your CPA classify it before you accept an offer, because the answer changes the after-tax price by hundreds of thousands of dollars.

From projects to passive income: the structures a retiring builder usually chooses

The point of the exchange is to stop running buildings without paying the deferred tax, and the replacement structures are chosen for that. A traditional DST holds institutional property under a master lease with no management role for you, and a financed trust or a zero cash flow, cash out DST supplies the replacement debt an investor coming out of a leveraged project needs. A direct title security suits a builder who wants to keep deciding when the next sale happens.

Builders are used to control, and a trust interest removes it: you cannot sell, refinance or re-lease, there is no public market for the interest, distributions can be cut, and the principal can be lost. Exchanging into raw land is the opposite choice, and it carries its own dealer risk if you plan to subdivide the land you buy.

Replacement property must itself be held for investment. A builder who exchanges into a building and then redevelops it for sale has acquired inventory, not investment property, and the exchange can be challenged on that ground alone.

The order of operations for the wind-down

Classify every asset in writing with your CPA. Sell inventory as inventory and plan for ordinary tax on it. For each investment project, engage a qualified intermediary before the contract closes, identify replacements within 45 days of each closing and close within 180, remembering that three projects sold in a year are three separate exchanges with three separate calendars.

Then stop building on the replacement side. The deferred gain follows your basis into the new interests, and an exchange that ends at death passes to heirs with a fair market value basis, which is the final piece of swap till you drop planning for an owner whose working life was spent creating the assets rather than holding them.