Real Estate Elevated: Can You Flip Houses With a 1031 Exchange?
No one likes paying taxes, but when you work at a normal 9:00-to-5:00 office job, unless you really examine your pay stubs every time you’re paid, it’s easy to forget about how much tax is taken out. Then, if enough was taken out throughout the year, you get a good chunk of change back when you file the next year.
In the real estate investing business, things are a little bit different. Every time you sell a property, you have to pay applicable capital gains taxes on it, which can really add up and cut into your profits. So what can you do? Some house flippers are looking to the 1031 exchange to save some cash, but can it work? First, you’ll need to understand what a 1031 exchange is.
What Is a 1031 Exchange?
A 1031 exchange occurs when you sell one property and then use the funds from that property to buy another one of equal or greater value. By doing this, you can defer your capital gains tax payment until you sell the second property. And, if you sell the second property and use its funds to buy another property, you can do another 1031 exchange to continue to defer the capital gains tax indefinitely.
One of the best things about a 1031 exchange is that you don’t have to keep buying more and more expensive properties. You can actually use your funds from selling one property to buy two others if you want. The biggest stipulation with a 1031 exchange is that you have to plan the new investment and close on it within a fairly short period of time.
With that information, you might think that 1031 exchanges would be perfect for house flippers, but certain requirements might disqualify some investors and/or some properties from being eligible.
1031 Works Better for Fix-and-Hold Properties
According to the IRS, a property should be held as an investment before a 1031 exchange is performed. However, in most states they don’t have an exact rule on how long you have to own a property before it is eligible for a 1031 exchange. If you attempt to perform a 1031 exchange on multiple houses in a year, especially houses that you bought and only held onto for a few weeks or months, the IRS will probably not allow your tax deferrals.
Basically, there are two ways that house flippers can take advantage of a 1031 exchange and avoid an audit from the IRS. If you hold a property for over a year, it will generally be eligible for a 1031 exchange. So, if you’re in the market to fix-and-hold properties as rentals for a year or more before selling them, then you could save a lot of money with 1031 exchanges.
Likewise, if house flipping isn’t your main source of income but rather a way to make extra money on the side, then you may be able to qualify for a 1031 exchange on one or two flip houses per year. You’ll want to talk to your CPA about this, though, to make sure that you qualify and that you aren’t in for a bad surprise later in the year.
In most cases, a 1031 exchange won’t be the ideal choice for house flippers, but it can work in some cases. If you don’t already have a great CPA on your team who’s intimately familiar with the tax codes relating to investment properties and making money with real estate, you need to hire one now. They could help you avoid some hefty tax payments and save you a ton of money.
For more information about real estate investing, visit Real Estate Elevated's BiggerPockets blog.