House Flipping and 1031 Exchanges Do Not Mix

A Primer on Real Property Considered "Held Primarily for Sale"

House flipping is a common investment strategy for those with the ability and time. We often field client questions asking: “If I’m purchasing this as an investment, why doesn’t it qualify for 1031 treatment?” The answer is found in Internal Revenue Code Section 1031(a)(1), which states that property that is "stock in trade" or "held primarily for sale” is specifically excluded from the benefits of 1031 exchanges. According to the Code, property that is held primarily for sale, whether to customers in the ordinary course of business or otherwise, is not property that is held for investment. That often includes property held by developers or by professionals who are routinely engaged in house flipping.

For example, a taxpayer who buys a house, makes renovations, and then quickly sells it for a profit may be considered to have held the property primarily for sale rather than for investment. Therefore, the taxpayer would not be able to defer the gain from the sale under Section 1031. Another example is a homebuilder that builds homes with the purpose of selling them is considered to hold the homes as inventory held primarily for sale, and those properties are not eligible for exchange. And, a taxpayer for whom a regular part of its business is selling real estate could be considered a dealer and also excluded from exchanging out of property sold that is considered inventory. The IRS will examine the taxpayer’s intent at the time of the exchange, so the more an investor/taxpayer can show an intent to hold property for investment, the greater the likelihood that the property will be eligible for exchange in any gray-area scenarios.

Factors that should be considered in determining whether a taxpayer holds property primarily for sale are:

1. The purpose for which the property was initially acquired
2. The purpose for which the property was subsequently held
3. The extent to which improvements, if any, were made to the property by the taxpayer
4. The frequency, number & continuity of sales by the taxpayer
5. The extent and nature of the transactions involved
6. The primary business or occupation of the taxpayer
7. The extent of advertising, promotion or other active efforts used in soliciting buyers
8. The listing of the property with brokers
9. The purpose for which the property was held at the time of sale.

This isn’t to say that the property cannot eventually qualify for 1031 treatment. One option would be to convert the property to a rental property for a period of time. A tax advisor can help an investor determine how long to use the property for such a purpose to show the requisite intent to hold for investment purposes, as opposed to primarily for sale.

Another possibility would be to move into the property as your primary residence for two years and then claim the exclusion available under §121 upon the sale. Be aware, however, that the exclusion will be pro-rated to account for the time that the property was not used as the primary residence.

Please don’t hesitate to contact First American Exchange with your questions and be sure to consult with your tax or legal advisor about your specific circumstances.