Why House Flippers Can’t Utilize 1031 Exchanges
January 31, 2022There is an interesting provision in Section 1031 of the Internal Revenue Code that allows property investors to defer capital gains taxes by using the proceeds from a sale to obtain a like piece of property. Unfortunately, the 1031 Exchange is not available to every real estate investor. For example, house flippers cannot utilize it.
The 1031 Exchange is a tax-advantageous strategy for reinvesting capital gains into one’s portfolio. Surprisingly, 1031 rules are pretty simple to understand. If you apply them in the right way, you can continuously use capital gains on sold properties to invest in new properties. But again, house flippers are left out of the party.
- Aimed at Investment Property
When 1031 Exchange rules were first introduced in the 1980s, the goal was to bring some sort of standardization to property investing – at least for tax purposes. Legislators were very clear about designating what constitutes investment property when the rules were written. Unfortunately for house flippers, fix-and-flip properties are not considered investments.
In the eyes of the law, house flipping is a business no different from buying used cars, repairing them, and selling them on a lot. For a property to be considered an investment, it must be held for a length of time. Moreover, the owner must derive some sort of investment benefit from the property as long as it remains in their possession.
- Rentals Are Investments
Rental properties are considered investments under 1031 rules. Understanding why is pretty simple. An investor holds on to rental properties for an extended amount of time. If you are talking residential properties, you’re looking at offering tenants one-year leases. If you are looking at commercial property, you are offering leases of two or three years. Both demonstrate a long-term commitment.
In theory, house flippers could adopt a strategy of purchasing residential properties, fixing them up, renting them for a year, and then selling them. The strategy could still be considered house flipping in some circles but, in the eyes of the law, it would no longer be a business. It would constitute investing in property.
- Short vs. Long Term
When all is said and done, what 1031 eligibility really boils down to is the difference between a short-term business asset and a long-term investment. Your typical house flipper wants to unload properties as quickly as possible. They do not want to be caught with properties that lose value in a volatile market. A property investor is not as concerned about short-term volatility because they are investing their money for the long term.
Incidentally, this understanding also explains why some hard money lenders will not touch fix-and-flip projects. Actium Partners is one such firm. As a Salt Lake City hard money lender, Actium Partners avoids fix-and-flip projects, construction loans, and other types of short-term projects that either don’t offer enough return or present too much risk.
- 1031 Exchanges in Brief
In closing this post, a brief explanation of 1031 Exchanges is in order. Again, remember that the point here is to defer capital gains tax.
If a property investor decides to sell a property, capital gains taxes can be deferred by rolling the proceeds of the sale into the purchase of another piece of property. However, the replacement property has to be similar in nature to the one that was sold. Both transactions are facilitated by a Qualified Intermediary who also holds the proceeds of the sale until the replacement property is acquired.
The 1031 Exchange is a great tax deferment tool available to property investors. Unfortunately, house flippers cannot utilize it. Their properties do not qualify as long-term investments.
