A basic requirement for relinquished property to qualify for §1031 exchange treatment is that the property must have been held for use in a trade or business or be held for investment. If a property is “held for sale,” it does not qualify for §1031 exchange treatment. Obviously, the fact that a property has been sold does not automatically mean that it was held for sale, otherwise no property ever would qualify for a §1031 tax-free exchange. But where is the line that, when crossed, means that a property has been held for sale? Recently, this issue was tackled by the California Office of Tax Appeals (“OTA”) in its opinion In the Matter of Moller et al, OTA Case Nos.: 230713806 through 230713812 (July 23, 2026). While state court decisions have zero precedential value in a federal income tax case, the fact that California follows federal income tax law and applies federal tax decisions in reaching its own tax decisions makes the case interesting reading.
In Moller, three families owned a corporation that was engaged in the property management, construction and brokerage business (referred to as “Services”), with the ownership being in a 50/25/25 ratio. Services obtained an option to acquire property, and Services thereafter submitted an application to a municipality to develop the property with approximately 350 residences. It also engaged an architecture and engineering firm to develop a master plan for the development. Thereafter, the three owners of Services each formed an S corporation, and the three S corporations formed an equally owned LLC (referred to as “Moller”), followed by an assignment of the option by Services to Moller. The terms of this assignment are not disclosed in the opinion nor is the reason for the revised ownership structure. Of note, is that the OTA indicated that the activities of Services were not to be attributed to Moller, and the Franchise Tax Board did not make such an assertion. (In this regard, the OTA cited to, among others, the seminal case of Bramblett v. Commissioner, 960 F.2d 526 (5th Cir. 1992), which permitted an installment sale of to be developed land to an affiliated entity to preserve capital gain in the land when the ultimate development would generate ordinary income.) A couple of years after exercising the option, Moller sold the property and acquired what it viewed as replacement property in a §1031 exchange.
In terms of whether property was held for sale or for investment, the OTA cited several federal cases in which taxpayers either won or lost. However, there are several key facts that appeared important to the OTA: (1) the sale of the property was in a single bulk exchange; (2) the taxpayer turned down numerous purchase offers to sell the property before its eventual sale; and (3) the taxpayer did not build homes, install roads or utilities, record final subdivision maps creating separate saleable lots or sell lots or homes. The OTA did acknowledge that
Ultimately, the OTA held for the taxpayer, although the OTA indicated that “[w]hile both parties provide compelling evidence, appellants provide stronger evidence in support.”…It would appear that in reaching its conclusion, the OTA was swayed by no physical subdivision or construction development to ready the property for sale after the entitlement work was performed – “[f]urthermore, Moller’s entitlement work does not necessarily show that the Property was held for sale, because preserving or enhancing the Property’s development potential is consistent with holding it as an investment.” The issue in Moller is a common one and one that is extremely fact sensitive. The line that Moller drew was that entitlement work was consistent with property held for investment, as long as that is where the development activity ended. Based on the analysis in Moller, albeit only one case and a state law case at that, installing utilities and grading the property likely would have been too much.
Like-kind exchange issues in the flow-through arena are commonly a major topic of discussion at every Tax Planning Forum® and Fundamentals of Flow-Through® program, and this year is no exception. We hope that you will consider attending either or both of these virtual or in-person programs or our new Fundamentals QAS self-study program. Registration is in full swing, and we encourage you to register soon, especially if you are interested in either of our in-person programs in Las Vegas (which is coming up soon) or Orlando where space is limited.
