Can you couple a 1031 Exchange with a fix n flip?
Six or eight years ago it was common to see evidence of “fix n flips” in the market place. Lending was easy so investors snapped up properties, remodeled the heck out of them or just gave them a quick face lift and lickity-split, they were back on the market again. Almost all had coated the walls with beige paint, installed beige flecked carpet underfoot. Some included newer bathroom fixtures, doors and upgraded kitchens too and others went as far as replacing wiring, HVAC systems and windows. Every flipper tidied up the yard and laid down mulch or “beauty bark”. Then the market stagnated. Sellers no longer had buyers knocking down their doors and lending become tougher for everyone. For the most part, fixer-uppers remained that way until their long term buyer came along.
Fast forward to 2012, when the market switched from the buyers being on top, back to a sellers market. Interest rates hit historic lows and investors came back with a vengeance. Depending on where you are shopping and the price point you are in, an average day looking at 6 houses with a buyer is bound to turn up at least one fix n flip. Few buyers don’t like a turn-key home, where the hard work has been done and the cost of the updating will be rolled into their low interest mortgage. There is definitely a place for these investors/flippers in the market today, as there was in 2007.
I work with investors and first time buyers… and everyone in between! Every so often one of the investors is exploring the possibility of a 1031 Exchange. In short, a 1031 Exchange is a way to defer capital gains tax owed after the sale of a property that is not/has not been your primary residence for at least 2 of the last 5 years. The idea being the investment property is sold and another is purchased within a very narrow time frame, allowing the real estate investor to take the proceeds of the first sale, have it held in escrow by a professional agency and then used to purchase the next property.
When can you use a 1031 Exchange ?
Well… it’s complicated and a large part of using a 1031 Exchange is your intent.
To qualify for tax deferral under section 1031, the property must be “held for” investment or to own the property for the taxpayer’s trade or business (“a qualifying purpose”). This “held for” requirement is not purely black and white. Rather it contains shades of gray.
- If the property was acquired with the principal intent to sell, like most flipped properties are, then the property is considered to be inventory and will not be eligible for tax-deferral under section 1031. The goal for most people acquiring property to rehab and thus intent, is for a quick sale and profit, not for an investment or business purpose. Therefore, instead of being able to use all of their profits, tax-deferred to purchase the next property, profits will be taxed as ordinary income.
- However if somebody buys a property to fix up to rent, then the principal intent is to own the property for trade or business – the business of renting. This qualifies as a proper use for section 1031 purposes. Likewise, if they acquire vacant land with the intent to hold the property for future appreciation, this qualifies as an investment use for 1031 purposes.
There is no one single factor that will prevail. Rather, courts tend to look at all factors to determine whether the taxpayer held the property for a qualifying purpose. They will consider;
- Length of time before selling
- Why the property was purchased
- How the property was used
- What improvements were made to the property
- The taxpayer’s ordinary business
- Number of prior sales (are their actions consistent with investing or selling inventory)
- How the property was being used when sold
So before you leap into dicey tax territory, consider the brain damage and cost that an IRS audit can deliver you if you throw caution to the wind and ride the gray line a little too long, or too often! Get good tax and legal advice from the get-go. Talk to a professional 1031 Exchange trustee at a reputable firm.
If you’d like to run your investment ideas past Dallice, need help in finding good professional advice or have a project in mind that requires a Realtor with 1031 Exchange and/or fix n flip experience, contact Dallice.