Everyone who purchases real estate considers it an investment and typically considers its potential resale value before acquiring it. However, IRS has different views of what qualifies as an investment property. Property held as stock in trade or primarily for sale is excluded from tax deferral treatment under section 1031. This would include properties acquired with the intention of “flipping” them. Additionally, these types of property are not considered capital assets and their sale are taxed as ordinary income not capital gains.
This issue has come up repeatedly in the past few weeks. When explaining this issue to property owners, we are often asked how to make these properties qualify or if holding them longer will make a difference. When it comes to 1031 exchanges, much more important than the length of time a property is held is the intention of the owner. What picture has been painted to IRS regarding your use of the property? Everything from the type of mortgage used to finance the property, the types of improvements made, correspondences with your professional advisors, the insurance coverage on the property and whether or not the property was rented all help demonstrate your intention to either hold the property for investment or hold the property for sale.
Many that “flip” properties appreciate the ability to defer gains under Section 1031 but then don’t like the requirements that must be met such as the need to acquire property of equal or greater value and reinvest all net proceeds. Often they prefer to keep some of the proceeds to make the improvements on the next property or need to payoff accumulated charges or lines of credit on another property to pay for the improvements to the property being sold. Typically they don’t usually want to acquire more than one replacement property at a time.
A dealer can have “true” investment properties and long-time investors may have properties that may not qualify. Owners that wish to preserve their ability to utilize 1031 exchanges are encouraged to clearly establish which properties are held for which purpose. A suggestion would be to set up an entity that only holds investment property, while a different entity holds only properties held for sale.
How can a property qualify? After the property is renovated, you can rent the property for a year or so, report it on your taxes as rental, claim the income and expenses and then list it for sale. This strategy should make the 1031 exchange a viable option.
Property owners should discuss their short and long-term investment strategies with their tax advisors to determine a plan that is best for them. Of course, the 1031 CORP. team is always available to answer any questions.