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Can sale proceeds from a “flipped property” be tax-deferred and used in a 1031 exchange to purchase other investment property?

April 11, 2016

 

Not so fast. To qualify for a 1031 exchange, you must hold the property after the rehab/renovation phase for (1) investment purposes, or (2) productive use in a trade or business (e.g., the business of renting). There is no “holding period” defined in the tax code, but professionals agree that 1 to 2 years is adequate (but, if an unsolicited offer is received on a property held for less than 1 year, and acceptance is economically solid, then the 1 or 2 years standard holding consensus is relaxed).

 

The exchanger’s “principal intent” to owning the property is critically important here. If the property was acquired with the principal intent to rehab and resell (i.e., a traditional flip) then the property is considered business inventory, which is ineligible for a 1031 exchange and profits from its sale are taxed as either ordinary income or long-term capital-gains income.

 

In the event of an audit, the IRS looks at many factors, such as why the property was bought, improvements made to it, length of ownership, and the exchanger’s ordinary business actions (is it consistent with real estate investing or selling flipped houses?). Itemizing the property on Schedule E, including rental revenues, expenses, and depreciation is a great way to prove 1031 exchange eligible ownership.

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