House flipping is a common income generator for those with the ability and time. There are even reality shows based on this type of real estate investing. You may wonder then “If I’m purchasing this as an investment, why doesn’t it qualify for 1031 treatment?” The answer is found in IRC 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.
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.
Factors that should be considered in determining whether a taxpayer holds property primarily for sale are:
- The purpose for which the property was initially acquired
- The purpose for which the property was subsequently held
- The extent to which improvements, if any, were made to the property by the taxpayer
- The frequency, number & continuity of sales by the taxpayer
- The extent and nature of the transactions involved
- The primary business or occupation of the taxpayer
- The extent of advertising, promotion or other active efforts used in soliciting buyers
- The listing of the property with brokers
- 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 it to a rental for a period of time. Some tax professionals would recommend renting it out for at least two years before exchanging into a new property. Additionally, the taxpayer could request a Private Letter Ruling from the IRS for their specific circumstances.
Stay up to date on the 1031 exchange industry, sign up for updates here.
Another possibility would be to move into the property as your primary residence for two years and then claim the exclusion available under §121. Be aware, however, that the exclusion will be allocated 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.