Can You 1031 Exchange A Fix and Flip Property?

Once again, it seems that many real estate investors are buying distressed properties, fixing them up, and putting them back on the market right away. And then they call us and want to do a 1031 exchange and roll the gain over into the next property. But can they?

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 means holding the property for future appreciation. Used in a trade or business means income producing, such as used in a business or used as a rental property. Typically with a fix and flip, you’ve never rented the property, so it’s not income producing. So the critical question then becomes: “did you hold it for investment?”

Section 1031 specifies that property “held primarily for resale” does not qualify for an exchange. There are two classic examples of held for resale: The first is a developer who buys bare land, re-plats it into lots, puts in streets, sewers and gutters, then sells the individual lots. The IRS calls these developers dealers, and the sale of the lots are taxed as ordinary income, so 1031 exchanges are not allowed. The second classic example is a fix and flip, where you buy a property, fix it up and then immediately try to sell it. These are both classic examples of property held for resale.

While flipping property for a quick profit has its rewards, you’ll be paying tax on the gain, and paying it at ordinary tax rates – not capital gain rates. However, if you intend to buy another property with the proceeds, doing a 1031 could save you a ton of tax—but you’ll have to jump through some hoops. You’ll have to rent it out, and you’ll have to hold it for at least a year. And no, you cannot buy it and take a year to fix it up. You need to rent it for at least a year, although it doesn’t matter if you rent it before you fix it up or after.

It’s a little uncomfortable to completely rehab a property, put a renter in it for a year, kick them out and then put the property up for sale, so many of our clients choose to rent it for a year, then fix it up, and then sell it. But some of our clients have fixed a property up and then rented it for a year with the understanding that the tenant will buy the property when the rental period has expired. If you decide to go this route (renting to the ultimate buyer), you should have your attorney structure the transaction for you. There are a couple of obscure IRS court cases that say that if the lease looks too much like a sale on an installment contract, the 1031 exchange can be disallowed. For this reason, we suggest that the right, or option, for the tenant to buy the property be handled by a separate document and not included in the lease.

If structured correctly you can do a 1031 exchange with a fix and flip providing you rent out the property, but you need to be careful and have a good 1031 intermediary to assist you.

“…if you intend to buy another property with the proceeds, doing a 1031 could save you a ton of tax — but you’ll have to jump through some hoops….”