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| everal months ago you
stumbled upon a |
property
sorely neglected by its previous owners. Your practiced
eye told you that there was a lot of money to be made
if you bought the property, fixed the deferred maintenance
items and did some basic cosmetic work.
Now
you find out that you were right—you’ve
received an offer that will return you a substantial
profit. But here’s the problem—tax will
eat a chunk of your profit—maybe as much as
half!
The good news: your buddy tells you about a 1031
exchange and how you can roll the gain from this
property to your next one. The bad news? You may
not qualify for a 1031 exchange unless you structure
the transaction correctly.
A
1031 exchange rolls the gain from the sale of your
old property into your new one. Both properties
have to have been held for investment, or used in
a trade or business, and you only have 180 days
from the sale of your old property to get your new
property purchased.
The problem is that Section 1031 says that it does
not apply to “property held primarily for
sale”. So how does the IRS know if your intent
was to hold it for investment, which would qualify
for a 1031 exchange, or hold it for sale, which
would not? The IRS will look at a number of factors,
including why you originally bought the property;
what you subsequently did with it; the extent of
the improvements you made to it; the number and
frequency of other transactions you’ve done;
the business you are in; the effort you went to
to find a buyer for your property; the listing of
the property for sale with real estate brokers;
and what you were doing with the property at the
time you sold it.
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“Fix and Flip”
Properties & 1031 Exchanges
By
Gary Gorman,
Managing Partner of The 1031 Exchange Experts
April
2003 |
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appeared in... |
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In
other words, if you make your living by buying fixers,
or building spec houses, and you always sell your properties
within a few months of the completion of the construction
or renovation, and especially if the income would be
“ordinary income” to you (as opposed to
short term capital gains), you have almost no hope of
your 1031 exchange passing IRS scrutiny in the event
of an audit. On the other hand, if you always hold your
properties for a considerable length of time, and this
one time the buyer came to you and made you an offer
you could not refuse, you probably will win if you are
audited.
What
can you do to structure your transaction as an exchange?
First of all, if you make your living building spec
houses or doing fix and flips, set up a seperate legal
entity, preferably an limited liability company (i.e.
an LLC) to hold the properties that you want to use
for exchanges. You need to build a firewall between
your exchange and non-exchange properties.
Second, you want to create paperwork that proves that
you intended to hold the property for at least a year.
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For example, you might want to advertise the fixer as
available for rent, on a one-year lease, beginning upon
completion of the remodel. If you do get a tenant, you
could give them an option to buy the property. If so,
put the option in a document separate from the least
and make the trigger date at lease a year and a day
in the future.
Be
smart and ask fair market value rents. Keep a copy of
the advertisements in your file as proof that you tried
to rent it.
Third,
do not list the property for sale with your real estate
broker. You can tell him that you’ll entertain
offers, but do not put anything in writing that proves
that you were interested in selling it.
Last,
while selling a property that you’ve held for
less than a year as outlined above should not be fatal,
don’t make it a practice to do so very often.
The more that you do so, and the higher the portion
of your exchanges you do on a short term basis, the
less likely it is that you will prevail if you get audited.
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