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Why 'flipping' won't work in a 1031 exchange
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?
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by
Nace Cohen, CPA, consultant with The
1031 Exchange Experts |
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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?"
After section 1031 says that the 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 an exchange. There are two classic
examples of held for resale. The first is the developer
who buys acreage, re-plats it into lots and puts in
streets, gutters and sewers, then sells the individual
lots. The IRS refers to them as dealers; the sale of
the lots is taxed as ordinary income and 1031 exchanges
are not allowed. The second is a fix and flip, where
you buy a property, fix it up and then immediately try
to sell it. To the IRS, these are classic examples of
held for resale.
If the IRS considers a flip as held for resale, is it
possible to turn it into investment property so that
you can do a 1031 exchange? The answer is yes, but the
IRS needs to see two things before they consider your
property an investment.
First, you need to hold it at least a year so that it
would qualify for long-term capital gains treatment
(they don'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 another tax year when you sell
it. Although not mentioned in the code section, it appears
these attributes weigh heavily in their decision to
decide whether your property was held for investment
or held for resale. 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 fast-appreciating property values, flipping
property for a quick profit has its rewards, but you'll
be paying tax at ordinary tax rates. If you intend to
buy another property with the proceeds, doing a 1031
could provide you with additional appreciation and the
additional proceeds that would otherwise go for tax
payments. To gain this benefit, just hold it for a year
and a day. If you rent it out during this time, you
might also gain additional cash flow.
Nace Cohen, CPA, is the manager of The 1031 Exchange
Experts Florida offices and is based in Naples.
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