Excluded Property

The list is gone. What remains is a single exclusion, and understanding why the others disappeared is more instructive than memorizing the ones that survived, because the reason governs how the residual categories are analyzed today.

13.1 The dealer exclusion as the only statutory exclusion

Section 1031(a)(2) now reads in its entirety: "This subsection shall not apply to any exchange of real property held primarily for sale."¹

That is the whole of the statutory exclusion. The Tax Cuts and Jobs Act, having limited section 1031 to exchanges of real property, rendered the remaining enumerated categories redundant. Stocks, bonds, notes, other securities, and choses in action are not real property, so no exclusion is needed to keep them out. They are excluded definitionally rather than by enumeration, and the definitional work is now done by the regulations examined in Chapter 14.

Two consequences of the restructuring are easy to miss and worth stating explicitly.

The statute no longer contains an exclusion for interests in a partnership.² This is not a liberalization. A partnership interest is excluded from the definition of real property by regulation, with the result that the outcome is unchanged while the reasoning has moved. Practitioners citing the former section 1031(a)(2)(D) for the proposition are citing a provision that no longer exists, and secondary sources continue to do so.

The rule governing partnerships that have elected out of subchapter K survived, but it moved. An interest in a partnership with a valid election under section 761(a) is treated as an interest in each of the assets of that partnership, and that rule now appears at section 1031(e).³ Its practical significance for co-ownership planning is developed at Chapter 21.

13.2 "Primarily" after Malat v. Riddell

The exclusion turns on a single adverb, and the Supreme Court has told us what it means.

In Malat v. Riddell the Court construed the word "primarily" as it appears in the capital asset definition, where property held "primarily for sale to customers in the ordinary course of" a trade or business is excluded from capital asset treatment.⁴ The taxpayer had acquired land with a dual purpose, intending either to develop it or to sell it depending on how financing developed. The Commissioner urged that a purpose is "primary" if it is a substantial one, which would have meant that any meaningful sales purpose defeated capital treatment.

The Court rejected that reading in a brief per curiam opinion. "Primarily," it held, means "of first importance" or "principally."⁵ A substantial purpose is not enough. The sales purpose must predominate.

Malat construed section 1221 rather than section 1031, but the same word appears in section 1031(a)(2) and carries the same meaning. The consequence for exchange planning is significant and favorable to taxpayers. A property owner who would sell at the right price, or who has an eventual exit in contemplation, does not thereby hold primarily for sale. Nearly every investor holds property that is available for sale on acceptable terms. What the exclusion reaches is the owner for whom selling is the principal purpose, which is to say the dealer.

The relationship to Chapter 12 should be kept in view. The holding requirement and the dealer exclusion are not independent tests applied in sequence. They are two statements of one inquiry, because property held principally for sale to customers is not held for investment. A taxpayer who satisfies Chapter 12 has generally satisfied this chapter as well.

13.3 Distinguishing dealer from investor

Because "primarily" describes a purpose, and purpose is proved circumstantially, the case law has developed a factor analysis. The leading formulation comes from the Fifth Circuit, which has produced the most extensive body of law on the question because it has produced the most subdivided land.

United States v. Winthrop enumerated the factors and remains the standard reference.⁶ They include the nature and purpose of the acquisition and the duration of ownership, the extent and nature of the taxpayer's efforts to sell, the number, frequency, and continuity of sales, the extent of subdividing, developing, and improving to increase sales, the use of a business office for the sales, the character and degree of supervision the taxpayer exercised over any sales representatives, and the time and effort the taxpayer habitually devoted to the sales.

Not all factors carry equal weight. The frequency and substantiality of sales is treated as preeminent.⁷ In Winthrop itself the taxpayer had sold roughly 456 lots, and profits from those sales over a thirteen-year period constituted 52.4 percent of his total income, while he devoted substantial time, skill, and financial resources to developing and selling the tract. The court concluded he had entered the business of subdividing real estate for sale.

Biedenharn Realty Co. v. United States refined the analysis en banc and is the second essential citation.⁸ Its practical contribution is the recognition that a taxpayer's original investment purpose does not immunize later activity. Property acquired and held for investment for many years may be converted by subsequent development and sales activity, and the tax character of the later sales is determined by the later conduct.

Three practical points follow for exchange planning.

Development activity is the most dangerous factor, because it is voluntary and visible. Subdividing, installing infrastructure, obtaining entitlements, and marketing lots are the acts that convert an investor into a dealer, and they are documented in county records.

The analysis is property-specific rather than taxpayer-specific in principle, though a taxpayer's general course of business colors the inquiry. This is the subject of 13.5.

Duration of ownership cuts both ways. A long hold supports investment purpose, but Biedenharn establishes that it does not survive a change in conduct.

13.4 Where the vanished categories went

A practitioner encountering a transaction involving something other than obvious real estate should not conclude from the shortened statute that the item now qualifies. The analysis has moved from exclusion to definition, and the definitional rules are at least as restrictive.

Treasury Regulation section 1.1031(a)-3(a)(5) lists intangible assets that are not real property for section 1031 purposes, and does so expressly "regardless of the classification of such property under State or local law."⁹ The list will be familiar because it substantially reproduces the categories deleted from the statute: stock other than cooperative housing stock, bonds or notes, other securities or evidences of indebtedness or interest, interests in a partnership, certificates of trust or beneficial interests, and choses in action. A separate rule denies real property treatment to a license or permit to engage in or operate a business on real property, while preserving it for a license in the nature of a leasehold or easement.

The significance of the phrase "regardless of State or local law" is developed at 14.6, but the point can be stated here. The regulations otherwise allow State law characterization to establish that something is real property. Paragraph (a)(5) is the exception that no State law characterization can overcome. A State might treat a particular interest as an interest in real property for its own purposes, and the item remains outside section 1031 if it falls within the excluded list.

The partnership exclusion carries the section 761(a) carve-out noted at 13.1, written into the regulation as well as the statute. The result is that a partnership interest fails section 1031 today for a different reason than it failed in 2017, with the same outcome. Practitioners should get the reasoning right regardless, because the reasoning determines the answer in novel cases where the enumerated list does not squarely apply.

13.5 Dual capacity and segregating investment property

The most common real-world question is not whether a taxpayer is a dealer but whether this property is dealer property, because many real estate businesses hold both kinds.

The governing principle is that dealer status attaches to property rather than to persons. A taxpayer may hold some parcels primarily for sale and others for investment, and the second group remains eligible for exchange treatment. The principle is easy to state and difficult to sustain in an examination, because the taxpayer's general course of business supplies an inference that the Service will press against every parcel.

What sustains the distinction is separation, maintained contemporaneously.

Entity separation is the strongest form. Holding investment property in an entity distinct from the development business creates a record that predates any controversy, and the disregarded entity rules of Chapter 19 mean this can usually be done without disturbing the same-taxpayer requirement.

Accounting separation follows. Investment parcels carried as fixed assets and depreciated, rather than carried as inventory, are treated by the taxpayer's own books as what the taxpayer contends they are. Inconsistent treatment is an admission, as noted at 12.5.

Conduct separation matters most for the factor analysis. Investment parcels should not be subdivided, improved for sale, or marketed through the sales apparatus of the development business. Each of those acts supplies a Winthrop factor.¹⁰

A caution to close. Because Biedenharn holds that investment purpose can be lost through later conduct, segregation is not a one-time act performed at acquisition.¹¹ It is a discipline maintained for as long as the property is held, and it is undone by a single episode of development activity conducted for convenience.