Fixer Upper: Can Taxes Make Your Deal A Flip Or Flop?

Paying capital gains taxes does not really lend itself to the excitement and drama of popular fix and flip shows. But determining if your property will qualify for the tax deferral benefits of a 1031 Exchange should definitely factor into your real-world analysis. Avoiding tax hits as you transition from holding to holding can increase the trajectory of your portfolio growth. Here are some things to keep in mind as you determine your approach to the tax consequences of real estate investment sales.

Intent

When it comes to paying or deferring taxes on the gain when you sell your investment property, intent is key. If you purchased with the primary intent of resale – either rapid fix and flip or cashing in on appreciation with a quick sale – then you will pay tax on the gain as ordinary income. But you have a choice of whether or not you will sacrifice real estate profit to tax immediately or use the tax to increase your own buying power. With 1031 Exchanges, you keep the taxes working for you by holding your investment for productive use. It all comes down to the question: why did you buy the property? If you purchased with the intent of holding for productive use, then a 1031 Exchange may be an option.

Hold Period

There's no statutory holding period for a 1031 Exchange, but the longer, the better. Most folks feel comfortable at more than a year. But there could always be circumstances where a shorter or longer hold period might be justified. To meet the IRS safe harbor provision and avoid any questions regarding the time an investment was held in case of an audit, the hold period should be two years. But many exchanges of property held less than two years also pass an audit. It is primarily about intent.

Actions Demonstrate Intent

For 1031 Exchange purposes, you must have the intent of holding it for productive use at the time of purchase. Your actions can demonstrate this as well as your documentation. Did you actually hold the property and generate income? Did you have it listed for rent? Can you document your intent via correspondence with your real estate and tax professionals? Do you have a history of flipping or holding? It is the entirety of how you act and what is documented rather than a single statement or event that verifies intent.

Change of Intent

Because life happens, 1031 Exchange rules and regulations allow for a legitimate change of intent after the time of purchase. For example, did your buyer make an unsolicited offer? Was there a significant change in the house/area/your circumstances that warranted a change in your intent? All of those things can be used. Sometimes accidents just happen. However, when the same accident happens several times in a row, it starts to look like intent and will be disqualified.

To Exchange or Not to Exchange

Your financial analysis before purchasing should include tax consequences. If you plan to fix and flip or quickly resell, be sure to include these substantial tax hits in your forecasts. If that makes your deal less than optimal, consider changing your plan to a longer-term hold. Keeping capital gains taxes working for your own benefit upon sale is an option if you decide to hold for productive use then transition to another investment with a 1031 Exchange. Remember that intending to rent out your rehab project for a period of time so you can take advantage of a 1031 Exchange does not preclude you from taking advantage of an unexpected and advantageous opportunity to sell it.