Do “Flip” Properties Qualify Under Section 1031?

Buying, renovating, and reselling real estate (commonly referred to as “flipping”) can be a highly profitable business endeavor. With interest rates remaining high, investors who can pay cash for aging properties often have the ability to buy at a low price point, make luxury upgrades and appointments, and then resell to more well-heeled buyers for whom high interest rates are less of a concern. However, many real estate investors are surprised to learn that they generally cannot work with a 1031 qualified intermediary to defer tax liability when selling these properties.

With that said, there are steps investors can take to qualify for indefinite tax deferral under Section 1031 if they so choose.

To see why “flip” properties generally don’t qualify for like-kind exchange treatment under Section 1031—and how real estate investors can achieve indefinite tax deferral—we can look at the language of Section 1031 itself. This article provides an overview of the key provisions of Section 1031 as well as some tips for real estate investors who want to prioritize securing indefinite tax deferral.

Section 1031: Why “Flip” Properties Generally Don’t Qualify

Why don’t “flip” properties qualify for like-kind exchange treatment in most cases? This is due to an exception that appears in Section 1031(a)(2) of the Internal Revenue Code. While Section 1031(a)(1) states that, “No gain or loss shall be recognized on the exchange of real property held for . . . investment,” Section 1031(a)(2) states:

“This subsection shall not apply to any exchange of real property held primarily for sale.”

Generally speaking, the IRS classifies “flip” properties as being held “primarily for sale.” Thus, even though these are investment properties, they usually don’t qualify for like-kind exchange treatment under Section 1031. When determining whether a particular property is held “primarily for sale,” the IRS considers factors including:

• The purpose for which the property was acquired
• The purpose for which the property was sold
• The duration of ownership
• The extent of any improvements made to the property
• The investor’s primary business or occupation
• The investor’s history of real estate transactions (and their timing)
• The investor’s efforts to sell the property

While these factors can all carry different amounts of weight in different circumstances, generally speaking, if a real estate transaction looks like a “flip,” the IRS will treat it as such. If an investor immediately undertakes substantial renovations upon acquiring a property and then lists it for sale promptly without engaging in any other income-producing activities at the property, there is a very good chance that the IRS will take the position that the exception to like-kind exchange treatment under Section 1031(a)(2) applies.

How Real Estate Investors Can Secure Indefinite Tax Deferral

With this in mind, what can real estate investors do if they want to secure indefinite tax deferral when buying, renovating, and reselling properties?

Qualifying for indefinite tax deferral under Section 1031 in this scenario involves taking the necessary steps so that a property will not be considered held “primarily for sale.” Typically, this means renting the property for a period of time. Investors who are interested in securing indefinite tax deferral can generally take steps, including:

• Holding the Property for More Than a Year – Holding the property for more than a year, while not required (or sufficient) in all cases, can help with demonstrating intent to profit from a long-term investment as opposed to purely holding the property for resale.
• Renting the Property for a Period of Time – Renting the property for a period of time can also assist with establishing a qualifying investment purpose under Section 1031.
• Engaging a 1031 Qualified Intermediary to Facilitate Their Exchange – By working with a 1031 qualified intermediary, real estate investors can both ensure that they are taking the steps necessary to qualify for like-kind exchange treatment under Section 1031 and that they will have the documentation they need to withstand IRS scrutiny if necessary.

Importantly, while these steps can help with securing 1031 exchange treatment, they won’t necessarily be sufficient in all cases. Especially when an investor has a history of flipping properties, an informed and well-documented approach is critical for avoiding unnecessary issues with the IRS.

Contact 1031 National Services | A 1031 Qualified Intermediary Serving Investors Nationwide

Do you have questions about securing indefinite tax deferral for your investment properties under Section 1031? If so, we invite you to get in touch. Call us at 888-872-1031 or contact us online to speak with a consultant at 1031 National Services today.