Purchasing two neighboring properties, capital gains when selling one?

Question

I'm looking at purchasing two neighboring properties (A & B) with a single owner carry note, rehabbing and selling property A, paying off part of the owner carry and then using rest the proceeds to rehab and hold property B.

Is there any way to structure the deal to avoid capital gains when selling property A?

Dave Foster · Answer

@Eric M.

@Christopher Tile is correct. A 1031 exchange could be an option, but in order to qualify for a 1031 exchange and defer all of the tax, the property you're selling and the property you're replacing must be held for investment use. The key factor here will be your "intent" for the property and how you demonstrate that intent. Fix-and-flips don't meet the criteria of the 1031 because they are held for such a short time and are also taxed differently.

What you could do is switch up your investment strategy and transition to more of a BRRRR strategy, which would demonstrate your intent to hold, and if you decide to sell the property later down the road, you could do a 1031 exchange.  The cash-out refinance allows you to continue full speed ahead with your fix-and-flips. But it will get you the runway to do 1031 exchanges and reap the benefits of the deferred taxes.

Jason Malabute · Answer

The question I'd start with isn't how to avoid the gain on A, it's whether A is going to be treated as investment property in the first place. Buying, rehabbing and reselling looks a lot like dealer activity, and if it gets characterized that way the property is inventory rather than a capital asset, which generally means ordinary income and self-employment tax on the profit. It also undercuts a 1031, because property held primarily for sale doesn't meet the held for investment or productive use requirement an exchange depends on. There's no bright line here, it's facts and circumstances, so what you intended when you bought, how long you hold, how many of these you do, how extensive the rehab is, and how you market it all get weighed, and objective conduct tends to carry more weight than stated intent. One transaction by itself doesn't automatically make you a dealer, but a pattern makes the argument harder. B is a different animal, since if you actually rent it, the rental income is generally outside self-employment tax and the property can be business or investment property. That's exactly why this is worth structuring before you close rather than trying to unwind it after. How it actually lands depends on your specific facts, so run the plan by your own CPA while you can still change it.

Ali Najjar · Answer

I would be careful assuming the seller financing changes the capital gains treatment. There may be ways to defer or spread the tax depending on how the transaction is structured.

I would have a CPA look at the exact structure before closing, especially since you are selling one property and putting the proceeds into another.

Michael Eskenasy · Answer

The first thing I’d nail down is the basis allocation between A and B when you buy them.

Buying both under one seller note doesn’t give you one giant basis you can move around later. You’ll need a defensible allocation of the purchase price between the two properties, generally based on their relative values. That basis is what matters when you sell A. (IRS⁠)

Also, paying down the seller note with the sale proceeds does not make the gain disappear.

The bigger issue is your intent with A.

If you’re buying A specifically to rehab and immediately resell it, it may be treated as property held primarily for sale rather than investment property. In that case, the profit may be ordinary business income rather than capital gain, and a 1031 exchange generally would not be available. (IRS⁠)

If A actually qualifies as investment/business property, then a properly structured 1031 could potentially defer gain by exchanging A into other qualifying real estate. But simply selling A and putting the cash into rehabilitating B that you already own is not the normal 1031 structure.

So before signing this, I’d have a CPA/tax attorney look at the entire transaction as one plan:

Buy A + B → rehab A → sell A → pay down note → rehab/hold B.

The tax treatment of A could change the economics enough that I’d want that answer before deciding how to structure the purchase.

Xavier Milsoni · Answer

Using an owner carry note across multiple properties makes the accounting and releasing of liens complex. Structuring it carefully with a tax professional is key to handling the sale of property A without a massive tax hit.

Ashish Acharya · Answer

@Eric M., the biggest thing I’d get right here is how the purchase price and seller-financed debt are allocated between Property A and Property B from day one.

If you buy both under one note and later sell only Property A, you’ll want a defensible basis allocation between the two properties rather than trying to figure it out after the sale. I’d want the purchase agreement, appraisal or other support, closing statement, and rehab records to clearly establish what portion of the acquisition cost belongs to each property.

The tax treatment can also be very different between the two. If Property A is purchased with the intent to renovate and resell, the profit may be treated as active/dealer business income rather than long-term capital gain. Property B, if genuinely held as a rental, would generally follow rental-property rules and could qualify for depreciation once placed in service.

I’d also keep the rehab costs completely separate. Improvements to A should not get mixed into B’s basis, and vice versa.

For Property B, I’d evaluate cost segregation after it is placed in service. It may accelerate depreciation, but the important question is whether you can actually use the resulting rental losses under your passive-loss situation.

I’d get the allocation and exit strategy documented before closing rather than relying on a 50/50 split later just because the properties were purchased together.

Happy to connect!

Eric M. · Answer

Thanks for all of the replies, it sounds like it would make more sense to hold both properties for awhile in order to exchange out of them at some point in the future. Cash out refi shouldn't be an issue with the ARV for each property.

Bill B. · Answer

With just those two properties it’s going to be difficult.

1) you can’t “fix and flip” property a, that doesn’t qualify for 1031

2) so you’d have to fix then rent out and the you could exchange it for a DIFFERENT property in a year or 2 or 3.  3) You can’t do the exchange in to property B because you already own that.

TLDR: you’d have to hold property a long enough to be considered a rental and not a flip.  When you sell it you would have to invest at least as much as the sales price. So that means paying off property a seller and buying property C with a new mortage from someone else. And no where do you get the funds to fix up property B. If you CRUSH it on property A remodel, and the seller terms aren’t any good. You could do a cash out refinance but you’re only going to get 75% of the ARV and you have to pay off seller. That means you have to add $1.33 in value for every dollar you spend just to break even (in cash) before refinancing costs.

Christopher Tile · Answer

Your concern should also include "dealer" status. If the plan is to buy+rehab+sell, that property would likely be considered for dealer/inventory treatment. You'd technically be in the flipping business which would do a few things. Most importantly, it would be treated as ordinary income + SE tax. Others include no 1031 eligibility (@Jason Wray), and no installment sale options either.

The real issue is not avoiding the gain but determining whether this is a flip or a legitimate investment property. This seems like a flip (ordinary income, no deferral tools available), however INTENT/holding period/nature of rehab, etc all are considered.

These are the exact situations that call for a conversation with a tax professional. We can all point out the items to watch for, but the actual determination/structuring around it... that all should happen before you close.

Jason Wray · Answer

Just do a 1031 Exchange.

Purchasing two neighboring properties, capital gains when selling one?

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