If you're reading this post you're likely asking the question: "Is there a way to defer the gains from one investment property sale to the next?" Yes, in fact there is, but it's complicated and in the end really should be done with the assistance of a qualified tax or legal professional. Below is the framework to get you started---Best Wishes!
If you aren’t buying a like property right away, the IRS allows you to designate three like properties (you don’t have to buy three, but you do need to designate at least one) that will replace the sold property; this is called the “Starker Rule.” The time cannot span more than six months from close to close and any residual cash is treated as boot – meaning you’ll need to pay tax on that amount.
Example: Brenda buys house one and it has a $50,000 embedded gain after several years of ownership. She doesn’t know exactly when she’ll buy the next property, but she doesn’t wish to pay tax on gain and is confident that she’ll reinvest in real estate in the near future. Brenda engages with a third-party to act as a middleman who holds the proceeds in escrow (Brenda does not take possession of the money.) Within 45 days of the sale of property one, she must nominate up to three properties as the replacement (1031) and submits that information to the middleman. Brenda decides to buy another house and the middleman uses the proceeds to close on the sale. The gains are then pushed into the second house.
Here’s the rub, house number two has to be of equal or greater net market value and equity. Also, if leverage (loan) was used on house one you’ll need to have equal or additional leverage on house two. If you don’t meet these requirements that’s fine, but the difference is treated as boot and therefore taxable.
Ownership must be the same. If Brenda's company, 90210 Properties, is the purchaser of house one, then it needs to be the purchaser of house two for the 1031 exchange to work. I don’t know if the IRS has stipulations on transferring the property once owned however.
There seems to be disagreement on the holding period requirements with regard to a 1031. Basically, if you’re flipping the IRS would interpret that clearly as property held for resale and therefore subject to the short-term rules -- no 1031 for you! Most tax advisors I’ve spoke with discourage short-term exchanges because they are very hard to defend if audited. The code also defines 1031 properties as properties “held for investment or for use in a trade or business” which I think puts the nail in the coffin for flippers trying to claim 1031.
Section 1031 rolls the gain from the sale of Old Investment Property over to New Investment Property tax deferred. Investment property is defined as property "held for investment or used in a trade or business." However, the code section then goes on to state that the code does not apply to property held primarily for resale.
If the IRS considers a flip as held for resale, is it possible to turn it into investment property so that you can do a 1031 exchange? The answer is yes, but the IRS needs to see two things before they consider your property an investment:
You need to hold it at least a year so that it would qualify for long-term capital gains treatment.
The IRS wants you to be in one tax year when you buy the property and another tax year when you sell it. Although not mentioned in the code specifically, it appears these attributes weigh heavily in their decision to decide whether your property was held for investment or held for resale.
A 1031 exchange is a complicated tax deferment and not one you should do without the guidance of a skilled tax advisor who has experience with these types of transactions. You also need to have a good game plan before selling such that you don’t end up take the sale proceeds as taxable.
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