1031 Exchanges: Fix and Flip Properties

Several months ago you stumbled upon a property sorely neglected by its previous owners. Your practiced eye told you that there was a lot of money to be made if you bought the property, fixed the deferred maintenance items and did some basic cosmetic work.

Now you find out that you were right-you've received an offer that will return you a substantial profit. But here's the problem-the capital gains tax will eat a big chunk of your profit-maybe as much as half!

The good news: your buddy tells you about a 1031 exchange and how you can roll the gain from this property into your next one. Now, the bad news? You may not qualify for a 1031 exchange unless you structure the transaction correctly.

A 1031 exchange rolls the gain from the sale of your old property into your new one. Both properties have to have been held for investment, or used in a trade or business, and you only have 180 days from the sale of your old property to get your new property purchased.

The problem is that Section 1031 says that it does not apply to "property held primarily for sale." So how does the IRS know if your intent was to hold it for investment, which would qualify for a 1031 Exchange, or hold it for sale, which would not? The IRS will look at a number of factors:

• Why you originally bought the property
• What you subsequently did with it
• The extent of the improvements you made to it
• The number and frequency of other transactions you've done;
• The business you are in
• The effort you went to find a buyer for your property
• The listing of the property for sale with real estate brokers
• What you were doing with the property at the time you sold it.

In other words, if you make your living by buying fixers, or building spec houses, and you always sell your properties within a few months of the completion of the construction or renovation, and especially if the income would be "ordinary income" to you (as opposed to short term capital gains), you have almost no hope of your 1031 Exchange passing IRS scrutiny in the event of an audit. On the other hand, if you always hold your properties for a considerable length of time, and this one time the buyer came to you and made an unsolicited offer you could not refuse, you could justify a 1031 exchange transaction.

What can you do to structure your transaction as an exchange? If you make your living building spec houses or doing fix and flips, set up a different legal entity, preferably a limited liability company (i.e. an LLC) to hold the properties that you will use for the 1031 Exchanges. It is important to build a firewall between your 1031 Exchange and non-exchange properties.

Second, you want to create paperwork that proves that you intended to hold the property for at least a year and a day, or two tax years. For example, you might want to advertise the fixer as available for rent, on a one-year lease, beginning upon completion of the remodel. If you do get a tenant, you could give them an option to buy the property. If so, put the option in a document separate from the lease and make the trigger date at least a year and a day in the future. Be smart and ask for fair market value rents. Keep a copy of the advertisements in your file as proof that you made an attempt to rent it.

Third, do not list the property for sale with your real estate broker. You can tell him that you'll entertain offers, but do not put anything in writing that proves that you were interested in selling it.

Last, while selling a property that you've held for less than a year as outlined above should not be fatal, don't make it a practice to do so very often. The more that you do so, and the higher the portion of your exchanges you do on a short term basis, the less likely it is that you will prevail if you get audited.