Can "Flips" Work in a 1031 Exchange?

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In a real estate market moving as fast as it is right now, "flipping" property seems to be the favorite pastime. Flipping is when you buy a property with the intent of turning around and selling it soon after the purchase. But can you do a 1031 exchange and defer the gain in a flip situation?

To qualify for a 1031 exchange, which rolls the gain from the sale of the Old Property to the New, both properties have to be held as an investment or used in a trade or business. Held for investment means you intend to hold the property for future appreciation over time. Used in a trade or business means the property produces income, like rental property. Since you don't rent the property in a flip, it isn't income-producing. So the question is, can a fix-and-flip be 'held-for-investment?'

Section 1031 says that exchange property must be held for investment or used in a trade or business. It goes on to say that property "held primarily for resale" does NOT qualify for a 1031 exchange.

There are two classic examples of held-for-resale. The first is when a developer buys bare land, replats it into building lots, puts in streets, sewers and gutters, then sells the individual lots. Because the IRS refers to these developers as "dealers," the sales of these lots are taxed as ordinary income and 1031 exchanges are not allowed. The second example is a fix-and-flip, where you buy a property, fix it up, then immediately resell it. The IRS deems both situations as classic examples of property held-for-resale and are therefore not 1031 exchangeable.

If the IRS considers your flip as held-for-resale, can you turn it into investment property and do a 1031 exchange? The answer is yes, but the IRS needs to see two things before they consider your property held-for-investment.

First, you need to hold it for at least a year so that it qualifies for long-term capital gains treatment. The IRS doesn't want you turning short-term capital gains into long-term capital gains by doing an exchange.

Second, they want you to be in one tax-year when you buy the property and a different tax-year when you sell it. Exchanging a property you bought and sold in the same tax-year is a no-no. We tell our clients that if you hold your property for a-year-and-a-day from any point in time, you'll be in one tax-year when you buy it, another when you sell it, and your property will qualify for 1031 exchange treatment.

In a market of rapidly appreciating property values, flipping property for a quick profit has its rewards, but expect to pay tax at ordinary rates. If you intend to buy another property with the proceeds, doing a 1031 exchange can provide you with additional appreciation and additional proceeds that would otherwise go for tax payments. To gain this benefit, just hold your New Property for a year-and-a-day. If you can rent it out during that time, you might even also gain additional cash flow.

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