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Can You Do A 1031 Exchange On A Quick Flip?

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Article by Al Aiello, CPA, MA Taxation

The answer is yes, provided you know the law in depth and plan accordingly. But first some background.

A 1031 exchange is a great way to create wealth by saving substantial taxes on the sale of investment property by reinvesting the untaxed sales proceeds in a replacement (investment) property within the IRS requirements of Section 1031 including the applicable regulations, rulings, and tax court cases. One of these requirements is that the properties in the exchange must be held for investment or business use. This requirement is known as the "holding requirement". The IRS interprets this "holding requirement" to mean that the relinquished and replacement property must be held for a certain time period. Therefore conventional thinking is that a quick flip of a property will not qualify for the tax deferral benefits of a 1031 exchange, because of this exchange holding requirement.

But this is based on IRS interpretation which does not have the force or effect of law. (The IRS does not have the authority to make laws; only congress does). Accordingly, the tax law does not give any specific, objective time period requirement. In other words, there really is no statute as to how long a property must be held before it qualifies as held for investment. A full-blown discussion of the background of all of this is beyond our scope. However here is an overview of some bottom-line recommendations to help you qualify for 1031 tax-free treatment on quick sales.

Know the tax law citations that support quick sales as exchanges

There are numerous cases. One is Rutherford, where the transfer was immediate. Others can be reviewed with a competent 1031 exchange specialist.

Avoid being a dealer especially by documenting investment intent

This was discussed in a another article titled, Will Wholesaling Make You a Dealer?

Hold the purchased replacement property for at least 2 years under the "Economic Unit" and "Continuity of Investment" doctrines – the foundation of qualifying exchanges

This is a strong indicator of investor status, even on the quick selling side of the relinquished property. Reason: These fundamental theories indicate that the relinquished and replacement properties are together as one unit where there is a long period of ownership and a very strong argument for investment intent and investor status. Therefore, under these doctrines, the longer holding period of the keeper replacement property should carry over to the short "flip" period of the relinquished property. Dating back to the 1920’s, these doctrines are foundational and thus a powerful defense against the IRS. (I know, as I have successfully used them in opinion letters for IRS examinations.)

Audit-Proof your exchange by audit proofing your taxes

If there is no audit there are no issues and no worry. "Audit-Proofing" (not getting audited) is the first rule of tax-reduction planning. Understand that nothing being done here is illegal, but is based on legal positions. So while you are taking such positions, you still have the legitimate right to employ audit proofing steps. One such step is to report all property transactions (including exchanges) on partnership form 1065. At the present time, partnership returns (form 1065) are audited less than other forms including Schedule E and corporation returns, 1120 or 1120S. (Because of its many tax disadvantages, you should not hold real estate in any type of corporation, anyway.) You should also properly complete form 8824 which is the specific IRS schedule for reporting 1031 exchanges. It is a supporting schedule to tax reporting forms (such as form 1065) and is the only exchange form that actually goes directly to the IRS. The complete and accurate filing of 8824 would mostly likely reduce your chances of an audit. You also should engage a Qualified Intermediary (QI) that specializes in complex exchanges, such as those combined with quick sales.

Al Aiello is a regular guest speaker at CT REIA. Go here for the current list of upcoming real estate investing seminars in Connecticut.

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