Tax Trap: Real Estate Flipping and the 1031 Exchange

We do a lot of work with real estate professionals.  This includes investors who buy and hold for cash flow and long term appreciation, along with “flippers” who buy, fix up and sell for short term gain.  Flipping has become an increasing trend and will be a popular activity for years to come.   Many TV programs show the speculative flipper making fast money buying and selling without taking on much risk.  But the question often comes from the flippers…can I utilize a 1031 tax deferred exchange for flip properties?

1031 exchange flipping houses

1031 exchange flipping houses

Section 1031 of the Internal Revenue Code (the “IRC”) was legislated into law back in 1921. Though there have been a number of changes over the decades, the overall theme has stayed the same. No gain or loss shall be recognized if real or personal property that is held for productive use in a trade or business or for investment is exchanged for property of a “like kind” to be held for either productive use in a trade or business or for investment.  So does flipping fall within the definition of section 1031?

So what are the rules…

On a basic level, the answer to this question is no.  A flip is characterized by short term and speculative intent.  What is the qualified purpose requirement of section 1031? Well the IRC does not clearly define “held for productive use in trade or business” or “held for investment.” It is clear that the qualifying property must be held for investment or use within the taxpayer’s trade or business. In general, real estate used in an exchange should have a long-term intent.  But how long the property needs to be held (or often referred to as the holding requirement) is just one of many facts and is not defined in the 1031 code.

The IRS has normally taken the position that two years is sufficient.  In addition, the IRS has generally viewed property acquired primarily to dispose of it (or held for resale purposes) as not being held for productive use in a business or trade.  Often real estate flips are treated as “inventory” as they are acquired for resale just like a furniture retailer acquires furniture.  In this situation, they are not deemed as being held for qualifying purposes.  In addition, being held for productive use in a trade or business would be compared to computers and desks utilized for employees in an office.  The shorter the time period that the property was held prior to or after an exchange, the stronger the facts must be to establish proper purpose and intent.

1031 exchange flipping houses

The IRS has ruled in Revenue Ruling 77-297 that a taxpayer could not purchase solely to exchange for another property. In Barker v. U.S., a property purchased solely to exchange for other property was determined to not meet the “held for” requirement.  Accordingly, if it is clear the intent was resale and not investment, then the transaction is ineligible for a 1031 tax deferred exchange.

However, the real estate acquirer needs to understand that intent can change based upon circumstances.  This can be dictated by family, medical, employment and macro and micro economic factors. If a real estate owner receives an unsolicited offer that makes economic sense in a short period of time, then that property may qualify for a 1031 exchange considering a review of all the facts and circumstances.

Consult a tax professional…

Was the property listed with a real estate agent for sale immediately after acquisition? If this is the case, the IRS could argue that the intent was never to hold the property for investment, but for resale like inventory.

Determining if a property qualifies for a 1031 exchange can be challenging depending on the facts supporting the holding period of the property and the taxpayer’s operations.  Real estate owners must watch that their property is not considered inventory or that they are considered a dealer which makes them ineligible for a 1031 exchange. Careful planning with a CPA or other tax advisor is suggested so that they understand relative arguments in support and against their position.  The tax considerations with flips may be more difficult than you thought.