How would you feel about selling your flipped investment property and saving upward of 35 percent on your ordinary income tax at the same time? That is what could happen if you qualified for a 1031 exchange on your next turn-around project, but unfortunately everything isn’t that cut and dry.
A 1031 exchange is a fantastic tax vehicle for real estate investors, but it might not be the perfect tool for home flippers or rehabbers. Using this method, the gain from the sale of a property is rolled into the next purchase, avoiding the Internal Revenue Service (IRS) and ordinary income tax at the same time. Assuming every subsequent property qualifies, investors can use a 1031 exchange to finance deals for years on end until they are finally ready to sell for a cash payout – paying tax on that final gain just once and at a long-term rate.
Can a 1031 exchange work for rehabbers?
Looking at a 1031 exchange, it is easy to see why it would be desirable for residential rehabbers. This vehicle can allow this type of investor to operate with less IRS involvement, cutting out significant tax costs along the way. However, there are requirements that define what type of property qualifies for a 1031 exchange, and in most cases flippers are left on the outside looking in.
The key to whether or not a 1031 exchange is a possibility is the purpose of your real estate purchase. Qualified properties must be bought and held for investment or for a trade or business. This excludes your home, and it prevents houses bought for a rapid resale from utilizing a 1031 exchange.
In simple terms, a quick buy-and-sell will often fail under IRS scrutiny. You’ll qualify for this tax-deferred strategy in the cases where you hold the property for more than a year and rent to tenants. But, it is important to remember that you can buy a home or residential property, fix it up and hold it for more than a year and still qualify – but that will often sink a flipper’s projected timeline and profit window, regardless of tax savings.
Understand tax law before you sell
A 1031 exchange is a fantastic tax ally for the real estate industry. That said, it isn’t right for everybody. When flipping homes, your best strategy is to understand tax law intimately before you sell, so you don’t run afoul of IRS rules and regulations.
When the housing market collapsed, distressed properties flooded the market. With an influx of foreclosed houses, home flipping became a desired and even glamorous profession, thanks to the rash of television shows that soon followed. Due to this popularity, the IRS quickly began to analyze these real estate transactions, and that increased the likelihood of a flipper facing an audit should he or she utilize a tax-deferred exchange like this one.
Prepare before you are audited
If you are facing an audit, know that the IRS will be looking at a several key elements to determine whether or not you qualify for a 1031 exchange: why you bought the property, what you intend to do with it – and what improvements you’ve already made – and how long you’ve owned it. If you bought it to sell, made a series of renovations over a few months and sold for a profit after six, you’re out of luck for a 1031 exchange.
Savvy rehabbers know how to use the IRS and tax structures to their advantage. In some select cases, a 1031 exchange is the right option – but it is better for other types of real estate investors and organizations. Before making the call, it is best to consult tax advisors and consultants who can shed some light on the correct methods to acquire an investment property with tax-deferred income.