It’s an investor’s dream scenario. You purchase a distressed property and start on the mountain of repairs and renovations. Then, someone else sees and wants—no, needs—your property.
Enamored by your real estate, they propose to pay you more than you paid. Before the sweat equity even begins to form on your brow, you receive an unsolicited offer at a handsome profit.
Profit without pain—what could be better? Well, profit without pain and no tax hit while unexpectedly moving on to the next investment property would be best case scenario.
Getting an Unsolicited Offer
This is exactly what happened to BiggerPockets member Jay. He is a rehab hold investor on a fast track to quitting his day job.
He purchased a rental property and was in the very initial stages of its rehab. Then, less than a month after closing, another investor spotted his smart play and offered him a handsome profit.
Despite his habit of buying and holding, at the time he received the offer, Jay had learned of a six-plex that would be the perfect addition to his portfolio. But he did not have the capital to hold and renovate the initial property and get the six-plex, as well.
Then came the unsolicited offer. Jay accepted the offer and began to work the numbers for the six-plex. He was very close, but the tax bill on the gain from the unexpected sale put the replacement purchase just out of reach.
If he could keep his taxes working for his own benefit using a 1031 exchange, it would be a game changer—but he didn’t think he had satisfied the hold period.
Holding Period for a 1031 Exchange
The hold period is only one of the ways that the IRS differentiates between dealers (intent to sell) and investors (intent to hold). Investors qualify for 1031 exchanges and dealers do not. A longer period of ownership can be one indicator of an investor’s intent to hold.
It was three days before he was to close on the sale from the unsolicited offer. Jay threw out a Hail Mary appeal post on the BP forum.
Based on his question and our follow-up conversation, I was able to show him how he could use all his profit—even the taxes—toward the purchase of his replacement six-plex.
Even though he had held the property only a short time, he and his accountant determined that he was eligible to defer all tax. This is because the IRS can take many factors into consideration when determining the intent of the investor in a 1031 exchange.
Typically, an investment property is considered to be held for trade, business, or investment and eligible for 1031 tax deferral when you have owned it for 12 months or more. Longer is better than shorter.
Showing Intent is Key
The keyword that the entire 1031 exchange statute hinges on is “intent.”
Think about the farmer who goes to an auction and buys a piece of land. Three months later, he sells it for 10 times what he paid.
Is he a dealer or investor? His intent can be determined by looking at his history, his actions, and his communication.
- He is a farmer with a history of holding property for productive use.
- Did he plant a crop on the purchased land?
- Or throw up a “for sale” sign?
- Did he seek out the buyer?
His history of holding for productive use, his action in planting a crop, and his lack of a “for sale” sign demonstrate intent. And the unsolicited offer is the strongest piece of evidence.
Much like Zillow’s “make me move” appraisal pricing, it’s hard to argue about a deal too good to refuse. I’ve heard many times from grizzled old professionals, “I’ll never sell anything—unless it’s the right price.”
This brings me back to Jay. He had a history of rehabbing and renting property. But he found himself in the process of selling a piece of property that he had only owned briefly and had intended to use for other purposes.
The unsolicited offer was that much more attractive due to his interest in purchasing the six-plex (aka a replacement property) to rehab and rent. Fortunately, he had clearly stated his intent with the first property to his family, friends, realtor, and tax professional prior to receiving the unsolicited offer.
Just because he received an unsolicited offer did not change his original intent. It did not mean he intended to flip the property all along.
He established his intent with integrity and could look at himself in the mirror and say, “I truly meant to hold this property.”
Preparing for a 1031 Exchange
Jay made his inquiry regarding a 1031 exchange just 72 hours before his closing. As soon as he decided to keep his taxes working for his own benefit instead of immediately forking them over to Uncle Sam, we jumped into action.
This is because a 1031 exchange must be in place prior to the sale of the investment property. And selling without the 1031 exchange would have made his distressed six-plex replacement property unattainable.
While 1031 exchanges have six requirements that must be adhered to, my team was able to walk Jay through the entire process. We coordinated with his closing team to prepare the necessary documentation. We handled all the background work while he focused on his sale and purchase.
He handily met all requirements and closed his sale and then his purchase.
Checking in on Jay
I checked in with Jay about six months after his exchange. He was just finishing up the renovation of his six-plex and had begun renting out units.
He was successfully able to leverage the unexpected windfall from his unsolicited offer and his own taxes into a bigger and better deal.
If you own real estate that you purchased with the intent to use for productive use in trade, business, or investment, you may qualify for a 1031 tax deferral, regardless of your holding period. The IRS created a safe harbor test in Rev. Proc – 2008-16.
However, it is important to understand that this safe harbor is not restrictive or definitive. Outside the safe harbor, no single method of documentation provides a fail-safe litmus test for 1031 exchanges. Yet, various case rulings support other measures.
Explore all options rather than harm your portfolio growth potential just because your circumstances are unique. And as always, seek counsel from a professional financial adviser familiar with your situation before making tax-related decisions.
Want to learn how you could be saving more on your real estate taxes using loopholes, deductions, and more? Get the inside scoop from Amanda Han and Matthew MacFarland, real estate investors and CPAs, in Tax Strategies for the Savvy Real Estate Investor. Pick up your copy from the BiggerPockets bookstore today!
Are you making the most of the tax benefits available to investors?
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.