Another Nail in the 1031 Fix-and-Flip Coffin

Whether a person can do an exchange on a fix-and-flip property (one that's been bought, fixed up, and put back up for sale) is a controversy that comes up from time to time--driven of course by taxpayers who have large profits on property they've owned for a very short period of time. We last saw a lot of interest in them when the real estate market was at the peak of the bubble. We're seeing it again as folks buy foreclosure properties, fix them up and put them back on the market.

Section 1031 rolls the gain from property held for investment over to new investment property. It specifically does not allow a gain rollover on property held for resale. The problem is that neither the Code, nor the Regulations define the terms investment or resale. The court cases mediating disputes between taxpayers and the IRS in this area typically focus on the taxpayer's intent--what were their intentions when they bought the property? 

Unfortunately this isn't very helpful because every taxpayer buys property as an investment, even when they sell it shortly after they bought it ("obviously it was a good investment or I never would have sold it"). And while most of the cases have ruled that you must hold the property for an extended amount of time to qualify as an investment, there are just enough cases where the courts have ruled in favor of short-term holdings (often mere months), to convince every desiring taxpayer that they too are the exception to the rule. 

A recent tax court case again makes clear that properties held for a short period of time between purchase and sale mean that they're held for resale and not investment. This case is not a 1031 case (the taxpayer's did not do exchanges on the sale of their properties), but since the court ruled that the properties were not investment properties, it provides an excellent discussion of how the court views short-term transactions. This should give us great guidance for future exchange transactions on property held for a short period of time. 

The taxpayer in this case was a mortgage broker who over a three-year period bought, fixed and sold 16 properties, holding them an average of two months--only one property was held longer than a year. None of the properties were rented before he sold them. 

In its opinion, the Court laid out nine factors it considers in determining if the property was held for investment or for retail:

1. Your intention in acquiring the property--what you say you're going to do with it. The taxpayer in this case said that he bought the properties to hold and rent.
2. What you ultimately did with it--he fixed them up and immediately listed them for sale. Once again actions speak louder than words.
3. Your everyday business (how you make your living), and the relationship of the gain to the other income in your return. The taxpayer in this case made about $40,000 a year as a mortgage broker, but several times that amount in profit from the real estate sales. Being a mortgage broker rather than, say, a doctor or a dentist, made him an insider in the mind of both the IRS and the Court and swayed them against him.
4. The frequency of the sales. This wasn't one isolated transaction; 16 transactions in three years means that he was doing a lot of deals. The more transactions of this type you do, the less likely that you'll prevail.
5. The extent of developing and improving the property to increase the sales revenue. The Court stated that the purpose of his efforts on each property was to create the maximum amount of gain in the shortest period of time.
6. The extent to which you use advertising and other promotional activities to increase sales. In other words, going back to factors one and two above, did you list it for rent or did you list it for sale after you bought it?
7. The use of a business office for the sale of the property.
8. The amount of control the taxpayer exercises over the person selling the property. In other words: if you own a condo building, set up an office in the building and hire a salesperson to sell the individual units, it will obviously count against you.
9. The amount of time that the taxpayer habitually devoted to the sales--or as one Appeals Court ruling noted, "the presence of frequent sales ordinarily belies the contention that property is being heldfor investment rather than for sale."

Now that I've given you a road map for how the IRS and the Tax Court approach sales of property held less than a year, put these in the context of the primary difference between held for investmentand held for resale, and that difference is intent--what's in your heart when you bought the property? Do most fix-and-flip properties qualify for an exchange? No. But are there sales of property that have not been owned long that do qualify for an exchange? Yes. Occasionally I get a call about a property that's only been owned for a short time that I think does qualify for a 1031 exchange. 

But consider this: you may be 100% correct in your belief that your transaction qualifies for an exchange, but are you willing to spend the tens of thousands of dollars it will cost you fighting the IRS over it?