Shades of Gray in 1031 Flips

Written by Patty Flowers. Patty Flowers is AVP for Investment Property Exchange Services (IPX1031®) and a Certified Exchange Specialist®. See her website.

Patty Flowers

Patty Flowers

Forget cooking shows, America’s newest reality show obsession is watching real estate shows such as Flip This House, Flip or Flop, and Rehab Addict. Seeing how a house is bought at a bargain price, quickly transformed and sold for large profits can be scintillating. In fact, it can entice many to try their hand at flipping properties. A big question often encountered is whether profits earned from a flipped property can be used, tax deferred, to purchase the next fixer-upper by structuring the purchase as a 1031 Exchange?

To qualify for tax deferral under section 1031, the property must be “held for” investment or to own the property for the taxpayer’s trade or business (“a qualifying purpose”). This “held for” requirement is not purely black and white. Rather it contains shades of gray.

To help understand the “held for” requirement, the two words “principal intent” are crucial. If the property was acquired with the principal intent to sell, like most flipped properties are, then the property is considered to be inventory and will not be eligible for tax-deferral under section 1031. The goal for most people acquiring property to rehab and thus intent, is for a quick sale and profit, not for an investment or business purpose. Therefore, instead of being able to use all of their profits, tax-deferred to purchase the next property, profits will be taxed as ordinary income.

However if somebody buys a property to fix up to rent, then the principal intent is to own the property for trade or business – the business of renting. This qualifies as a proper use for section 1031 purposes. Likewise, if they acquire vacant land with the intent to hold the property for future appreciation, this qualifies as an investment use for 1031 purposes.

There are other important factors considered by the courts. These can include length of time before selling, why the property was purchased, how the property was used, what improvements were made to the property, the taxpayer’s ordinary business and number of prior sales (are their actions consistent with investing or selling inventory), and how the property was being used when sold. There is no one single factor that will prevail. Rather, courts tend to look at all of the facts to determine whether the taxpayer held the property for a qualifying purpose.

Flips can be lucrative and create a reward of a quick profit. However with most flips, you will be paying taxes at ordinary income tax rates. If your intent is for business or investment and you meet certain criteria, then your property may qualify for 1031 treatment. In areas of gray, consider the benefits of a 1031 compared to the potential costs of an IRS audit, interest and penalties compared to paying taxes due. Talk to your tax or legal advisor to review your individual circumstances.

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Washington Update – 1031 Under Attack

Written by instructor Patty Flowers. Patty Flowers is AVP for Investment Property Exchange Services (IPX1031®) and a Certified Exchange Specialist®. See her website

 

Patty Flowers

Patty Flowers

1031 Exchanges have been an integral part of real estate’s recovery. Now the government is proposing to eliminate all 1031 Exchange activity.

For decades, real estate investors, business owners and Fortune 500 companies have used 1031 Exchanges to defer the payment of capital gains tax and depreciation recapture tax associated with the sale of their investment properties. 1031 Exchanges also allow taxpayers to maintain or diversify their portfolios and increase their purchasing power. Any investment property or property held for productive use in a trade or business, ranging from vacant land to shopping centers, can be exchanged. The taxpayer must simply purchase new qualifying real estate and follow some basic rules to complete a tax deferred 1031 Exchange.

Even though 1031 Exchanges have long been recognized as a major factor in encouraging real estate sales, as part of tax reform in separate Discussion Drafts, the House of Representatives, Senate and the President’s Budget Office have all proposed eliminating or sharply curtailing the benefits of Section 1031:

  1. House Ways & Means Committee Chairman Dave Camp released a Discussion Draft of his Comprehensive Tax Reform Proposal on February 25, 2014. The Camp Proposal would repeal Code Section 1031 for like-kind exchanges occurring after 2014.
  2. Senate Finance Committee Chairman Max Baucus’ tax reform Discussion Draft includes a proposal to repeal Section 1031 in its entirety. The proposed repeal would apply to exchanges made in taxable years beginning after December 31, 2014.
  3. President Obama’s 2015 Budget proposal also contains significant changes to IRS Code 1031. The President’s proposal does not eliminate 1031 Exchanges, but limits the amount that can be deferred to $1 million per taxpayer per year.

The elimination of 1031 Exchanges will result in a sharp decrease in real estate transactions. Due to its severe impact on all areas of the real estate community and how this could potentially affect you, IPX1031® will keep you up to date on these proposals. Simply send an email to info@ipx1031.com to be added to the “Washington Update” list.

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1031 Tax Straddling for 2014

Written by instructor Patty Flowers. Patty Flowers is AVP for Investment Property Exchange Services (IPX1031®) and a Certified Exchange Specialist®. See her website

Patty Flowers

Patty Flowers

With the end of 2013 approaching, there are investors selling real estate who are not sure whether to initiate a 1031 Exchange because they are concerned about securing replacement property. One thing to keep in mind is that the IRS does not penalize investors for attempting to complete a 1031 Exchange. However, if investors cannot successfully complete their 1031 Exchange, the taxes associated with the sale of their investment property will be due. The good news is at this time of the year, there may be a silver lining. “Tax straddling” may be an option where the taxpayer receives a one year tax deferral.

How does it work? Once a 1031 Exchange is initiated, if replacement property is not purchased to complete the exchange, the earliest the Qualified Intermediary can return the taxpayer’s funds is on the 46th day (the day after the identification time period has ended) or, in some cases, the 181st day (the day when the 1031 Exchange time period is complete). Taxpayers who enter into a 1031 Exchange during the fourth quarter of 2013 and receive their funds back from the Qualified Intermediary in 2014 have the option of deferring payment of taxes on the profits from their sale until 2015 – the due date of their 2014 tax return. Combining §1031 with §453 permits the cash received from the Qualified Intermediary at end of the exchange to be treated as a payment in the year of actual receipt, rather than in the year the property was sold.
Tax straddling provides added incentive to taxpayers selling investment property at the end of the year. Why not attempt to complete a 1031 Exchange when a one year deferral is available as the back-up plan?
Taxpayers should consult with their tax advisors since tax straddling does not apply to all sales, and any gain attributed to debt relief will still have to be recognized in the year of sale. It is also important that the taxpayer has the intent to complete the 1031 Exchange when the 1031 account is opened.
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