ELI5, why do people put profits into a 1031 vs a tax write off
Rental Property Investor · Excelsior, MN · Member since 2019 · 21 posts · 4 votes
ELI5, why do people put profits into a 1031 vs a tax write off
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Ashish AcharyaBusiness Member
CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votesOriginally posted by @Mitchell Rusten:
Simply put, why do real estate investors need to put their profits on something like a flip into a 1031 exchange rather than simply putting the profits into a new property and writing off the acquisition like a normal business would? When McDonald’s makes a profit on a hamburger, they don’t have to enter the framework of something like a 1031 exchange to avoid paying the taxes on the profit and using it to buy more hamburgers, they just write off the acquisition of more hamburgers and don’t pay taxes on it until they eventually decide to step out and stop their continuous acquisition of more profitable hamburgers. Other than when a property can’t be found before the end of the tax year, is there a reason I’m not aware of that says you can’t make $40k on a flip and use buy 2 houses for $20k + hard money and avoid taxes rather than having to abide by the rules of a 1031 exchange?
1) You can’t put profit from from flip into 1031. 1031 is not for an ordinary income.
2) no, reinvesting the profit into another property is not going to give you write off. The profit you make from one sale is taxed even if you reinvest into another property.
What you are describing is not normal in the flip business. Let’s say you made 10k in one flip and then go buy another property with that flip profit. you still will be taxed on that 10k as you can’t deduct the purchase price of the 2nd property when you buy it. If you happen to sell the second property, it will generate its own profit. So you have profit from two flips.
If one flips gives you 10k and other gives you -10k, the net is zero, then you don’t have income. But why flip two houses and still make no money? That’s happens when you are in bad luck.
Bottom line is reinvesting money doesn’t give you tax shelter.
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9 Replies
- 6yAshish AcharyaBusiness MemberCPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
Originally posted by @Mitchell Rusten:
Simply put, why do real estate investors need to put their profits on something like a flip into a 1031 exchange rather than simply putting the profits into a new property and writing off the acquisition like a normal business would? When McDonald’s makes a profit on a hamburger, they don’t have to enter the framework of something like a 1031 exchange to avoid paying the taxes on the profit and using it to buy more hamburgers, they just write off the acquisition of more hamburgers and don’t pay taxes on it until they eventually decide to step out and stop their continuous acquisition of more profitable hamburgers. Other than when a property can’t be found before the end of the tax year, is there a reason I’m not aware of that says you can’t make $40k on a flip and use buy 2 houses for $20k + hard money and avoid taxes rather than having to abide by the rules of a 1031 exchange?
1) You can’t put profit from from flip into 1031. 1031 is not for an ordinary income.
2) no, reinvesting the profit into another property is not going to give you write off. The profit you make from one sale is taxed even if you reinvest into another property.
What you are describing is not normal in the flip business. Let’s say you made 10k in one flip and then go buy another property with that flip profit. you still will be taxed on that 10k as you can’t deduct the purchase price of the 2nd property when you buy it. If you happen to sell the second property, it will generate its own profit. So you have profit from two flips.
If one flips gives you 10k and other gives you -10k, the net is zero, then you don’t have income. But why flip two houses and still make no money? That’s happens when you are in bad luck.
Bottom line is reinvesting money doesn’t give you tax shelter.
INVESTOR FRIENDLY CPA®5241 Reviews - Specialist · Paradise Valley, AZ · Member since 2018 · 3k+ posts · 2k+ votes6y
Originally posted by @Ashish Acharya:
Originally posted by @Mitchell Rusten:
Simply put, why do real estate investors need to put their profits on something like a flip into a 1031 exchange rather than simply putting the profits into a new property and writing off the acquisition like a normal business would? When McDonald’s makes a profit on a hamburger, they don’t have to enter the framework of something like a 1031 exchange to avoid paying the taxes on the profit and using it to buy more hamburgers, they just write off the acquisition of more hamburgers and don’t pay taxes on it until they eventually decide to step out and stop their continuous acquisition of more profitable hamburgers. Other than when a property can’t be found before the end of the tax year, is there a reason I’m not aware of that says you can’t make $40k on a flip and use buy 2 houses for $20k + hard money and avoid taxes rather than having to abide by the rules of a 1031 exchange?
1) You can’t put profit from from flip into 1031. 1031 is not for an ordinary income.
2) no, reinvesting the profit into another property is not going to give you write off. The profit you make from one sale is taxed even if you reinvest into another property.
What you are describing is not normal in the flip business. Let’s say you made 10k in one flip and then go buy another property with that flip profit. you still will be taxed on that 10k as you can’t deduct the purchase price of the 2nd property when you buy it. If you happen to sell the second property, it will generate its own profit. So you have profit from two flips.
If one flips gives you 10k and other gives you -10k, the net is zero, then you don’t have income. But why flip two houses and still make no money? That’s happens when you are in bad luck.
Bottom line is reinvesting money doesn’t give you tax shelter.
But, on the "Flip" side (pun intended) not doing a 1031 exchange, paying the tax and having access to cash for other opportunities on your own time frame may be a better play from time to time.
I have done flips where I made $100,000, paid the tax and simply bought a couple of cash flowing properties using Subject To and taking over existing mortgages. Having the tax write offs associated with two properties, the principal pay down, the increased cash flow, the depreciation and the appreciating assets more than covered the amount I paid in taxes. Meeting the strict requirements of a 1031 exchange would not have worked.
You have to run the numbers before you commit to any one strategy and use the one that makes sense for the market you are in and what you want to accomplish.
- Investor · brentwood, CA · Member since 2016 · 1k+ posts · 730 votes6y
That gives new meaning to the term "hamburger flipper" :)
- 6yJeff CichockiBusiness MemberLender · All 50 States · Member since 2015 · 401 posts · 250 votes
As a general rule of thumb, the IRS doesn't allow flips to be 1031 into something else. 1031's are for rolling over long term capital gains into new projects and delaying the payment of taxes on those funds.
However, for those that do qualify for a 1031, there are other ways to 1031 that are not well known. This goes way beyond your question, but there are strategies called "Reverse 1031" and "1031 Alternative". I don't work with the reverse ones, but I do help people with the latter. It is possible to pull 95% of the cash out of a 1031 and not pay taxes on it for 30 years. There is very little documentation on this strategy out there. It is very well guarded as no one wants the IRS to get the laws changed to outlaw it. It's ridiculously powerful and really help you multiply profits and get additional depreciation on the same dollars.
Good luck on what you're trying to do.
Best REI Funding4.36 Reviews - Rental Property Investor · Excelsior, MN · Member since 2019 · 21 posts · 4 votes6y
@Mike M.
So that is obviously the part I am confused on. So if I made, say. $20k on a flip then went and put $40k in another house, wouldn’t that be $20k in revenue and $40k in expenses if we don’t include financing? So I would show -$20k in profit for the year, but I’d still have to pay taxes on the $20k I made on the one sale?
- Specialist · Paradise Valley, AZ · Member since 2018 · 3k+ posts · 2k+ votes6y
Originally posted by @Mitchell Rusten:
@Mike M.
So that is obviously the part I am confused on. So if I made, say. $20k on a flip then went and put $40k in another house, wouldn’t that be $20k in revenue and $40k in expenses if we don’t include financing? So I would show -$20k in profit for the year, but I’d still have to pay taxes on the $20k I made on the one sale?
Generally, if you made $20,000 on a flip at the 15% tax rate that is $3,000 tax. (simple numbers, it's far more complicated than that) But, that isn't enough money to make it worth stopping progress while looking for the 1031 exchange. I can use the remaining $17,000 and perhaps buy a better deal than I might wind up with on a 1031 exchange (there are costs to do the exchange by the way) or I could get started on the next flip sooner. IMHO.
The IRS treats flips differently than long term holds. You get far more favorable tax incentives when you hold onto a property. My point is that on occasion it makes sense to do a flip to create cash which is higher taxed and then purchase some buy & holds with that money. The actual numbers are dependent on too many things to get too specific but it includes your total tax picture including if you have W2 income. If all you did in a year was a single fix & flip and had no other source of income it computes one way, but that isn't realistic.You still have to have money to pay bills and survive and go onto the next flip. So that money and those taxes and write offs have to be accounted for. Plus, if you are doing flips a 1031 exchange is more challenging to do because the time pressure sometimes forces you to make a bad decision on buying the next property. Also, it is likely there is additional income coming from somewhere. It makes since to buy some tax software and put in different scenarios to see the different outcomes. I did comparisons years ago and as a result I gave up flips and went with cash flow (long term holds). Still, on occasion, I'll do a flip but my other tax write offs more than compensate for the tax hit I take when I sell the flip. - Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes6y
I think the main item you're missing is you don't just get to write off a purchase for a rental.
You can't do a 1031 on a flip.
But if you sell a flip and make $20k. You pay tax on that 20k. What you do with your proceeds after tax has no impact.
If you take your $15k profits after tax and buy a rental for $30k you don't get to write off 30k. Long term assets are depreciated so you buy a house for 30k and you deduct part of it every year over its 27 year life,. - Investor · San Francisco, CA · Member since 2016 · 338 posts · 444 votes6y
@Mitchell Rusten, I think the answer you’re looking for is that it’s just one of those things that’s different with real estate investing as treated by the IRS. It might feel the same as flipping burgers on a large scale, but it’s treated as a different category of business with unique rules. Some of those rules are more advantageous than a traditional business but it’s different and you can’t expense real estate purchases as “inventory” or some such.
I get what you’re asking though and if you dig deep into tax code there are so many rules that seem arbitrary and apply to one industry but not another.
- 6yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
@Mitchell Rusten, I like the metaphor. And several folks have of course told you that flips in the real estate world where the property you purchase with the primary intent of resale (flipping) do not qualify for 1031 treatment.
So the reality is that most people who flip houses do not do 1031s. But that doesn't mean they've stumbled onto the "special sauce" (cmon give me some credit here). In fact they're paying tax just like McDonalds.
McDonalds does not get to write off the new makings of the hamburger. There is a basis for each and all of the ingredients - both all beef patties, special sauce, lettuce, cheese, pickles and onions and the sesame seed bun. In accounting these are called "cost of goods" sold. Let's be generous and say that the "cost of goods" for a Big Mac is 50 cents. When they sell that Big Mac for $3.50 they make a profit of $3.00. They pay a tax on that profit after accounting for operating expenses.
When the truck backs in with the next load of ingredients it does not write off the sale of the old Big Mac. It provides the cost of goods "basis" for the new Big Macs and is purchased with after tax dollars in a manner of speaking.
Same with real estate flippers - The property, dry wall, tile, paint, and appliances are costs of goods to create a house to sell. When the house is sold it is netted against the basis (the cost of goods) of the property. And the flipper pays tax - and a lot of it. Because ordinary income tax for a flipped burger or a flipped house is a lot of cheese (I'm so amused with myself) compared to paying capital gains tax rate.
Believe me, if McDonalds could do 1031s they would. There's a lot of folks that think they keep their burgers that long anyway.
As a real estate investor you have the option of flipping and paying tax on the flip profit. Then reinvesting in a new property to flip with after tax dollars. Or you can have a different intent. And choose to hold property for a time before selling and pay capital gains tax. Or doing a 1031 and paying no tax or depreciation recapture. It's whatever you want.
I prefer aged steak over fast food!
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