“Fix-and-Flips” ...Exchangeable? or Audit-Fodder?

A couple of months ago, you discovered a real diamond-in-the-rough -- a good house in serious disrepair. Upon closer inspection, you realize that all of the problems are merely cosmetic. With a little money and hard work, this ugly duckling can become a beautiful, and highly lucrative, swan.

So, you acquire the property, perform your work, and a couple of months later, you list the property for sale. Happily, you soon receive a full-price offer-- netting you a sizeable profit! Not so happily, you discover that short-term capital gains taxes will eat a huge chunk of your earnings! What to do?

Take heart - all is no lost. You may be able to do a 1031 Exchange. However, a "fix-and-flip" must be structured in exactly the right manner to potentially qualify for a 1031 Exchange. And, even then, performing a 1031 Exchange on a "fix-and-flip" is a risky proposition because of the very nature of the "flip," or quick resale.

A 1031 Exchange rolls the gains from the sale of your Old Property into your New Property thereby deferring your capital gains taxes. Both Properties must be held for business or investment, and you have 180 days from the closing of your Old Property to purchase your New Property.

The problem is that Section 1031 does not apply to "property held primarily for sale." And, the typical "fix-and-flip" is intended to be resold immediately after the remodel. So, how would the IRS divine this intent? They can examine a wide array of factors. Why did you originally buy the property? What kind of improvements did you make to the property? How quickly did you actually sell the property after you acquired it? At purchase, did you give any indication of an intent to sell? How many other similar transactions have you done in the past? What type of business are you in?

In other words, if you make your living by doing "fix-and-flips," and you always sell immediately after completion, you have almost no hope of surviving an IRS audit. On the other hand, if you typically hold your properties for a substantial length of time, and this one time a buyer made you an offer you couldn't refuse, you may survive an IRS audit.

There are a few things you can do to protect yourself in the event of an audit. First and best is to not sell the property for at least a year after completion of the improvements. But, assuming this is not the plan -- after all, we don't call these "fix-and-wait-and-flips" -- there are other precautions you can take.

If you make your living doing "fix-and-flips," create a separate legal entity, like an LLC, to hold each property that you wish to exchange. As a result, you erect a "firewall" between your exchange property and the other property you own. Therefore, if your exchange fails, your other property will be insulated from any negative IRS ramifications.

You should create a paper trail demonstrating your intent to hold the property for the long-term - over a year is a good guideline. For example, you could advertise the fixer for a one-year lease after completion. If you get a tenant, you can give them an option to purchase the property -- though, draft a separate option agreement and set the option exercise date at least one year after the commencement of the lease. Also, keep copies of your rental advertisements as proof of your intent to rent it. However, do not lie or fabricate proof -- penalties for tax fraud are a lot worse than paying some taxes!

Also, do not list your property for sale with your real estate broker. Tell your broker that you'll entertain offers, but don't enter into a listing agreement or put anything in writing that shows your intent to sell. Lastly, don't make "fix-and-flips" a frequent practice. The more you do this and the higher the number of exchanges you perform in a short period of time, the more likely you lose an audit.

An exchange on a "fix-and-flip" is iffy. However, if you are willing to accept that an audit may disallow the exchange, it can be a handy tool in your investment arsenal.