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In a real estate market that is moving as fast as Florida's, "flipping" property seems to be the favorite pastime for many people. Flipping is when you buy a property with the intent of selling it very soon after the purchase. But can you do a 1031 exchange and defer the gain in a flip situation?

In order 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 refers to intent to hold the property for future appreciation. Used in a trade or business means income producing, like rental property. In a flip, you've never rented the property, so it's not income producing. So the question really is, "Did you hold it for investment?"

We get this question all the time, "What will the IRS look for if they audit my exchange?" A 1031 Exchange is reported on form 8824, "Like Kind Exchanges," and attached to the taxpayer's tax return. Section 1031 of the IRC actually has two parts, real estate and personal property exchanges. Regarding real estate, a 1031 exchange joins together the sale of Old Property with the purchase of New for the purpose of deferring taxes. In today's appreciating real estate market, the deferred tax savings can be significant, so rest assured the IRS will examine the whole transaction in an audit, not just numbers and dates.

Once again, it seems that many real estate investors are buying distressed properties, fixing them up, and putting them back on the market right away. And then they call us and want to do a 1031 exchange and roll the gain over into the next property. But can they?

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 holding the property for future appreciation. Used in a trade or business means income producing, such as used in a business or used as a rental property. Typically with a fix and flip, you’ve never rented the property, so it’s not income producing. So the critical question then becomes: “did you hold it for investment?”

This article remains posted for it's historic context only -- some info herein is outdated.

Recently I wrote an article analyzing a private letter ruling (PLR 200251008), released at the end of last year (Using 1031 Funds to Build on Property You Already Own, Colorado Real Estate Journal, July 16, 2003). This decision allowed a taxpayer to use exchange proceeds from the sale of one property to build improvements on a piece of land that they already owned.

This ruling came as a shock to the exchange industry because it completely departed from a major 1951 tax court case (Bloomington Coca-Cola v. Commissioner) that disallowed such a scheme. Now, within a few months of the first ruling, the IRS has released a second ruling (PLR 200329021) that again allows a taxpayer to use exchange proceeds to build on their own land.