The case law on this type of 1031 Exchange transaction shows that the IRS may consider the exchanger to be a “Dealer” rather than an investor which will disqualify the transaction as a 1031 exchange relinquished property sale. The case law varies in outcomes, but generally, this is not a safe way to proceed.
Here is an example of a case where the seller could have used a 1031 exchange to realize greater returns.
FACTS: I am going to call this the “Little Old Lady from Pasadena” example. We had a client that owned a 20 unit apartment building with her husband in Pasadena, California, for over 25 years. The husband dies and the surviving spouse, who is now in her middle 70’s, decides to sell this investment property and then purchase a Replacement Property, that is not as Management Intensive. The apartment building has appreciated considerably since the client and her husband had purchased the property 25+ years ago. Her Realtor advised her that she can make a considerable amount more of a profit if she sells each of the units as a Condominium and she, the Realtor, will also make more of a commission. A Win-Win situation for both the “Little Old Lady from Pasadena” and the Realtor. The Realtor is very successful and obtains contracts for the sale of all of the units. Prior to closing on any of the units, the seller decides to do a Section 1031 exchange with the proceeds. Read the Lesson’s Learned section below for the rest of the story.
LESSON’S LEARNED: The “Little Old Lady from Pasadena” was found to be a “Dealer”, not an “Investor” because she converted an investment into a business of selling units, due to multiple sales and multiple buyers. As a result, she will be taxed ordinary income taxes on profits. She would have received as a net figure, more money if she had just sold the entire building. She could also have completed a Section 1031 exchange.
