Do flips qualify for 1031?

Question

I heard only rental properties qualify for 1031, but not flips. Is this true?

Bill Exeter · Answer

@Costel A. and @Christian Bors,

The most important element in this discussion is your ability to demonstrate under audit that you had the intent to hold for rental, investment or business use.  Property held for sale (e.g., inventory in a rehab/flipping business) generally does not qualify for 1031 Exchange treatment.  However, you can reposition or change your intent with sufficient time to demonstrate that your intent has changed to intent to hold vs. intent to sell.

Dave Foster · Answer

@Costel A. and @Christian Bors.  Property that has been purchased with the primary intent of immediate resale (yes, fix n flips as they are traditionally understood) does not qualify for1031 treatment.  But I would caution against thinking too restrictively that only "rental" property qualify either.  Property that qualifies for 1031 treatment is property that you have purchased with the intent of holding for productive use in business trade or for investment.  So rentals yes but also holds for appreciation like land in the path of progress, property you house your business in, property that is used as part of a business etc.  Rental income provides good evidence of your intent but is not a statutory requirement.

One easy tweak to a strategy can change fix n flips from non-qualifying to qualifying for 1031s.  Instead of fix and immediately flip, fix, rent, wait a bit, and then flip.  Yes it slows you down a little but it provides you the opportunity to enjoy both the tax benefits of depreciation and tax deferral through the 1031.  It also lets you get additional appreciation from the property while you hold it.  And if you're really impatient you can a always refi once the reno is complete and tenants are in place.

Clayton Mobley · Answer

@Costel A. While it looks like @Dave Foster already got you the info you asked for (and, as a qualified intermediary, he would know!) I thought I should toss in a few other 1031 pointers for you if you're thinking of using this tax deferral mechanism.

Firstly, bear in mind that in addition to your intent being paramount, you also would need to meet several important deadlines and requirements to execute a 1031, so it isn't something you could just pull the trigger on quickly. Not only do you have to identify up to three like-kind properties within 45 days of closing on your sale - which means you should be looking long before you put your property on the market - but you also need to close on a new property within 180 days of your sale, or the whole thing falls apart. In addition, if you decide to identify more than three like-kind properties as options for exchange, then you're subject to some other very specific rules regarding how many of your identified properties you must purchase and the total value of all identified properties relative to your sold property  (called the 95% exception and the 200% rule) in order for the exchange to be valid.

You also need a qualified intermediary, like Dave, to handle everything so the money from your sale never touches your hands. If you sell your property and take payment to your account, of any amount, from that sale, the exchange is void.

Also bear in mind that the tax burden from your exchanged property does not just disappear, it is deferred. The tax basis of your new property is simply reduced by the amount of the deferral so that when you sell that property, you essentially pay taxes for both the first and second property simultaneously. You can, of course, keep exchanging until you die or do some complicated things with charitable trusts, but the jist here is that the tax man cometh no matter what.

1031 exchanges can be really useful tools for deferring tax burden and maximizing the buying power of your current capital. However, they aren't a magic bullet solution to avoid taxation and there are plenty of rules to abide by - the IRS isn't keen on just giving out loans after all. If you're considering using this tool, just be sure to do all you due diligence and get real comfortable on the IRS website ;)

Best of luck!

Clayton

Dave Foster · Answer

@Costel A., There's no statutory holding period.  But there's some rules of thumb to discuss with your financial advisors to see where you should land in your particular situation.

1. Longer is usually better than shorter - The mantra used to be "a year and a day".  But that's not in statute and there're reasons why you may purchase something with the intent to hold yet need to change that intent and sell the property less than a year.  Strangely enough this is a result of the IRS willingness to attack some exchanges (typically on raw land developments and cases of significant lengthy renovations) where the hold time was much more than a year by claiming that the intent all along was really to resell.  By opening the door in this way to scrutiny of longer term holds they also opened the door to use "intent" which may change in less than a year or more than a year

2. Your past and current investing practice helps to demonstrate your "intent" to hold.

3. The real key is that it boils down to what your intent is/was.  If you decide to put a renter in then do it with the intent of holdlng and evaluate the situation later to see if your intent needs to change.  Accidents can happen and a property may need to be sold very quickly.  As long as you document and demonstrate your intent wasn't to primarily resell then you should be good.  Where people get into trouble is when those "accidents" of short holding happen 6 or seven times a year.

Costel A. · Answer

@Clayton Mobley and @Dave Foster, thank you guys, that was very useful information.

Costel A. · Answer

Thank you guys, this is very important information.

Dave, for how long do I have to rent it before the property qualifies for 1031, six months, one year, longer?

Christian Bors · Answer

@Costel A.  That is true.  The IRS views flipping as a dealer.  Flips do not qualify for the 1031 exchange.

Do flips qualify for 1031?

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