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Why Flipping and Section 1031 exchanges are not compatible

By
Services for Real Estate Pros with Atlas 1031 Exchange, LLC

In recent years, flipping or purchasing a property with the intent to quickly resell for profit has been a common staple for those looking to make a return on their investment of sweat equity and speculation.  TV offers programs of the experienced and the all too rosy eyed flipper learning the hard way their perceived improvement budget is woefully shy or their asking price too aggressive to meet their expectations.  What about the tax consequences?

 

Section 1031 of the Internal Revenue Code was legislated into law in 1921.  Though it has undergone a number of changes over the past eighty seven plus years, the premise remains the same.  No gain or loss is recognized if real or personal property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.  The Internal Revenue Service Office of Research, Analysis and Statistics reported in Tax Year 2004 taxpayers filed more than 338,500 Form 8824s, claiming more than $73.6 billion in deferred gains (or losses).   This is a two fold increase in the number of exchanges reported while the total dollar amounts deferred more than tripled since 1998. 

 

Flipping is before you buy a property your intent is to sell it soon after.  Is flipping eligible for 1031 consideration?  No and the answer lies in the facts.  Whether the property is held for proper purpose is the taxpayer's burden of proof.  What is the qualified purpose requirement?  IRC §1031 does not define "held for productive use in trade or business" or "held for investment."  Qualifying property must be held for investment or use within the taxpayer's trade or business.  The taxpayer's intent or purpose for holding the relinquished or old property and the replacement or new property is determined when the exchange takes place. 

 

How long the property needs to be held or better known as the holding requirement is one fact of many, and is not defined in the 1031 code.  The Service takes the position that two years is sufficient.  In addition, the Service views property acquired primarily to dispose of it, held for resale, rather than to hold for productive use in a business or trade, or to allow it time to season as an investment, a sale not an exchange or held for qualified purposes.  The shorter the time held before or after an exchange, the stronger the facts must be to establish proper purpose or intent. 

 

Revenue Procedure 2008-16 provides clarification for vacation homes held as investment property stating the property must be held two years and rented fourteen overnights per year to be considered "safe harbor" or the IRS will not challenge the investment property.  To further clarify, the old property must be held two years prior to the exchange and the old property must be held two years after the exchange.  Each year, the property must be rented a minimum of fourteen days.  

 

The Service ruled in Revenue Ruling 77-297, that a taxpayer could not purchase solely to exchange for another property.  In 1987, in Barker v. U.S., property purchased solely to exchange for other property will not meet the "held for" requirement.   Each case is based upon the intent at the time of the exchange and the facts that support the intent.  If it is clear the intent was resale and not investment, then the transaction is ineligible for a 1031 tax deferred exchange.  Intents change based upon medical, family, work and economic factors.  If an unsolicited offer is received that makes economic sense in a short period of time, is this eligible?  Yes given the proper intent and supportive facts.  Was the property listed with a Realtor for sale or was a "For Sale" sign posted soon after the purchase?  If so, then the Service may argue the intent was never to hold for investment but for resale.  Always seek the advice of your accountant before initiating an exchange.  Given they complete Form 8824 filing your exchange, you will want their approval before the exchange.

 

It is a slippery slope qualifying property for 1031 exchanges if the property is not held for the proper intent and supportive facts real or personal property was held for investment or in the taxpayer's business.  Better yet, hold the property for at least a year and a day to qualify for long term capital gains rather than learning later the property is not eligible for a 1031 tax deferral and subject to ordinary income taxes.  If the property is a vacation home, it is suggested the property is held for two years with 14 days of rental income in each of the two years.  Realtors, Developers, Building Contractors must watch that their property is not considered inventory or that they are considered a dealer which makes them ineligible for 1031s.  More planning is suggested for their transactions.   Be sure to visit www.atlas1031.com for more insight into 1031 exchanges.

Ted Mackel
Keller Williams Realty Simi Valley - Simi Valley, CA
Simi Valley Real Estate Agent
Welcome to Active Rain.  Make sure to check out other blogs so you can see what works and what does not.
Apr 15, 2008 10:03 AM
Keith Elliott Jr
KEIRE Realty Group - Manassas, VA
Principal Broker/Owner

Hello Andrew,

Welcome to Active Rain and congrats on your first post! The opportunities to learn and network are incredible here. Best of luck to ya!

-Keith

Apr 15, 2008 11:54 AM
The Trumm Team Omaha Homes for Sale, Real Estate
Keller Williams Greater Omaha - Omaha, NE

Welcome to ActiveRain!

If you would like a few tips on getting the most out of ActiveRain, please visit my blog Welcome to Active Rain.  It has a few simple steps of what to do now that you have joined.

If you ever have any questions, just let me know.

Troy Trumm
Apr 15, 2008 01:45 PM
Bill Kennedy
Keller Williams Greenville Upstate - Greenville, SC
Homes For Sale Greenville SC
Welcome to active rain!  This is a great forum for learning and for passing on information.  Enjoy it and watch out - it's addicting!
Apr 15, 2008 02:36 PM
Benjamin Clark
Homebuyer Representation, Inc. - Salt Lake City, UT
Buyer's Agent - Certified Negotiation Expert

Welcome to Active Rain! For some tips on how to get started here, check out my blog entry at ActiveRain Fast-Start Tips for Quick and Easy Points

Happy blogging and good luck!

Apr 15, 2008 06:03 PM
Temple Callahan
Connect Real Estate - REALTOR / BROKER - Ventura, CA
Search Ventura County Homes For Sale CA

Thanks for this info!  Good to know..

Mar 20, 2015 01:54 AM