Why 'flipping' won't work in a 1031 exchange

In a real estate market that is moving as fast as Florida's, "flipping" property seems to be the favorite pastime for many people. Flipping is when you buy a property with the intent of selling it very soon after the purchase. But can you do a 1031 exchange and defer the gain in a flip situation?

In order to qualify for a 1031 exchange (which rolls the gain from the sale of the old property to the new), both properties have to be held as an investment or used in a trade or business. Held for investment refers to intent to hold the property for future appreciation. Used in a trade or business means income producing, like rental property. In a flip, you've never rented the property, so it's not income producing. So the question really is, "Did you hold it for investment?"

After section 1031 says that the property must be held for investment or used in a trade or business, it goes on to say that property "held primarily for resale" does not qualify for an exchange. There are two classic examples of held for resale. The first is the developer who buys acreage, re-plats it into lots and puts in streets, gutters and sewers, then sells the individual lots. The IRS refers to them as dealers; the sale of the lots is taxed as ordinary income and 1031 exchanges are not allowed. The second is a fix and flip, where you buy a property, fix it up and then immediately try to sell it. To the IRS, these are classic examples of held for resale.

If the IRS considers a flip as held for resale, is it possible to turn it into investment property so that you can do a 1031 exchange? The answer is yes, but the IRS needs to see two things before they consider your property an investment.

First, you need to hold it at least a year so that it would qualify for long-term capital gains treatment (they don't want you turning short-term capital gains into long-term capital gains by doing an exchange).

Second, they want you to be in one tax year when you buy the property and another tax year when you sell it. Although not mentioned in the code section, it appears these attributes weigh heavily in their decision to decide whether your property was held for investment or held for resale. We tell our clients that if you hold your property for a year and a day from any point in time, you'll be in one tax year when you buy it, another when you sell it, and your property will qualify for 1031 exchange treatment.

In a market of fast-appreciating property values, flipping property for a quick profit has its rewards, but you'll be paying tax at ordinary tax rates. If you intend to buy another property with the proceeds, doing a 1031 could provide you with additional appreciation and the additional proceeds that would otherwise go for tax payments. To gain this benefit, just hold it for a year and a day. If you rent it out during this time, you might also gain additional cash flow.