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“Fix-and-Flips”
...Exchangeable?
or Audit-Fodder?
A
couple of months ago, you discovered
a real diamond-in-the-rough -- a good house in serious
disrepair. Upon closer inspection, you realize that
all of the problems are merely cosmetic. With a little
money and hard work, this ugly duckling can become a
beautiful, and highly lucrative, swan.
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by
Curtis Moore, Esq.,
Consultant, The 1031 Exchange Experts |
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So,
you acquire the property, perform your work, and a couple
of months later, you list the property for sale. Happily,
you soon receive a full-price offer-- netting you a
sizeable profit! Not so happily, you discover that short-term
capital gains taxes will eat a huge chunk of your earnings!
What to do?
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| and
by Gary Gorman
Founding Partner,
The 1031 Exchange Experts |
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Take
heart - all is no lost. You may be able to do a 1031
Exchange. However, a "fix-and-flip" must be structured
in exactly the right manner to potentially qualify for
a 1031 Exchange. And, even then, performing a 1031 Exchange
on a "fix-and-flip" is a risky proposition because of
the very nature of the "flip," or quick resale.
A
1031 Exchange rolls the gains from the sale of your
Old Property into your New Property thereby deferring
your capital gains taxes. Both Properties must be held
for business or investment, and you have 180 days from
the closing of your Old Property to purchase your New
Property.
The problem is that Section 1031 does not apply to "property
held primarily for sale." And, the typical "fix-and-flip"
is intended to be resold immediately after the remodel.
So, how would the IRS divine this intent? They can examine
a wide array of factors. Why did you originally buy
the property? What kind of improvements did you make
to the property? How quickly did you actually sell the
property after you acquired it? At purchase, did you
give any indication of an intent to sell? How many other
similar transactions have you done in the past? What
type of business are you in?
In other words, if you make your living by doing "fix-and-flips,"
and you always sell immediately after completion, you
have almost no hope of surviving an IRS audit. On the
other hand, if you typically hold your properties for
a substantial length of time, and this one time a buyer
made you an offer you couldn't refuse, you may survive
an IRS audit.
There are a few things you can do to protect yourself
in the event of an audit. First and best is to not sell
the property for at least a year after completion of
the improvements. But, assuming this is not the plan
-- after all, we don't call these "fix-and-wait-and-flips"
-- there are other precautions you can take.
If you make your living doing "fix-and-flips," create
a separate legal entity, like an LLC, to hold each property
that you wish to exchange. As a result, you erect a
"firewall" between your exchange property and the other
property you own. Therefore, if your exchange fails,
your other property will be insulated from any negative
IRS ramifications.
You should create a paper trail demonstrating your intent
to hold the property for the long-term - over a year
is a good guideline. For example, you could advertise
the fixer for a one-year lease after completion. If
you get a tenant, you can give them an option to purchase
the property -- though, draft a separate option agreement
and set the option exercise date at least one year after
the commencement of the lease. Also, keep copies of
your rental advertisements as proof of your intent to
rent it. However, do not lie or fabricate proof -- penalties
for tax fraud are a lot worse than paying some taxes!
Also, do not list your property for sale with your real
estate broker. Tell your broker that you'll entertain
offers, but don't enter into a listing agreement or
put anything in writing that shows your intent to sell.
Lastly, don't make "fix-and-flips" a frequent practice.
The more you do this and the higher the number of exchanges
you perform in a short period of time, the more likely
you lose an audit.
An exchange on a "fix-and-flip" is iffy. However, if
you are willing to accept that an audit may disallow
the exchange, it can be a handy tool in your investment
arsenal.
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