Can You 1031 a Flip? When You Can Exchange a Rehabbed Property

IRC Section 1031 is set up to prevent use by those who are merely buying properties to flip them, but there are situations where a house flip can also be an investment that satisfies the requirements for tax deferral.

If you’re wondering, “can you 1031 a flip?”, the answer depends on whether the property was truly held for investment or primarily purchased for resale.

Real property, or real estate, is often a long-term investment. Whether you’re a homeowner who has spent decades paying off your primary residence, or an investor in residential or commercial properties, the longer you hold your property, the more its value can increase. When you sell, you’ll have to pay capital gains taxes, which will greatly decrease the amount you can walk away with; that’s why some taxpayers try to hold their property investments until their deaths, so their heirs can benefit from a step up in basis.

The U.S. tax code has several sections that encourage activity in the real estate market. Section 121 provides an exclusion for a person’s main home, so you can keep more of the proceeds when you sell your primary residence. For business and investment properties, there is Section 1031, which allows for the deferral of capital gains, depreciation recapture, and other taxes on the sale of business or investment real estate if the proceeds are used to acquire like-kind property.

Investors have long used 1031 exchanges to reinvest the equity they’ve built up in their properties into new high-value properties, building more wealth over time. Like-kind exchanges help people save for retirement, grow small businesses, and earn passive income. This tool ensures people don’t just sit on property investments, but instead pursue opportunities without being penalized.

But what about house flipping, where investors buy a property with the intention of rehabbing it and selling it at a higher price? For investors considering 1031 exchange flipping houses strategies, the key question is whether the property was held for investment or acquired primarily for resale. While this can be a viable career for some, there are rules in place to prevent Section 1031 from being used to defer taxes on these property sales. But that doesn’t mean it’s disallowed in every case. Understanding the intricacies of Section 1031 and how they’re interpreted could allow you to plan a situation where you can flip a house and continue deferring taxes.

Can You 1031 a Flip? When a 1031 Exchange Is Held Primarily for Sale

First, the bad news: Section 1031 of the Internal Revenue Code does include language that is intended to prevent its use by those purchasing properties in order to execute a quick flip. The law states, “This subsection shall not apply to any exchange of real property held primarily for sale.” This is often the central issue in a 1031 exchange held primarily for sale analysis: if you acquire a property with the intention of turning around and selling it at a profit, your exchange won’t be allowed.

But here’s the good news: the law does not include exact requirements for what constitutes “primarily for sale.” If you hold your property for long enough to establish that it was acquired as an investment and not just to be sold, your exchange could be allowed.

Why the 1031 Exchange Holding Period Matters

How long must you hold a property for it to qualify? Again, the law doesn’t say. It is standard practice to hold a property for at least two years before it is sold, but there are always exceptions. This is why understanding the 1031 exchange holding period and related investment-use expectations is so important when planning a transaction. If you receive an unbelievable offer, the government will not force you to turn it down. Every case is unique. But if you want to give yourself the best chance of a successful exchange, it’s a good idea to hold the property and rent it for two years before you exchange.

Two years might be too long for those whose business is rehabbing and selling homes over and over, but 1031 tax deferral is not intended for them. Individuals whose primary vocation is the buying and selling of property may be classified as dealers of real estate, and any exchange these individuals attempt would likely be denied. This is one reason a real estate dealer 1031 exchange is often difficult, because dealer property is generally treated as inventory rather than investment property.

If you’re a seasoned house flipper and you buy and sell multiple houses every year as part of your business, Section 1031 is likely not for you. But if you’ve found an opportunity to rehab a property and sell it at a profit, and you establish business use by renting it out for a time, you could defer taxes on the sale and use more of your sales proceeds to invest in future properties.

Using an Improvement Exchange for Rehab Property

There are specific advantages available to those who currently own business or investment property and want to exchange into a property that must be rehabbed. With an improvement exchange, you can use some of the tax-deferred sales proceeds to make improvements to your replacement property during the exchange. For investors researching an improvement exchange rehab strategy, this can make it possible to acquire a replacement property valued lower than your relinquished property, make improvements on it using the excess sales proceeds, and continue to defer taxes on the full amount as you rent and eventually sell your new property.

This is how Section 1031 could be advantageous in a house flip scenario. Let’s say you own a single-family home as an investment property, and have found a distressed property in a good area that could be profitable if rehabbed. You could perform an improvement exchange into this new property and make the necessary upgrades during the exchange. You then rent it out for a time to establish business use and eventually exchange from that property into a new high-value property. Your tax deferral continues into the new investment, with even more accrued value because of the profit you made on your sale.

House flipping may not be allowed under Section 1031, but depending on the situation, something that is almost a house flip (but technically not) could be a viable strategy. That’s why getting expert tax and legal advice is so important: there are exceptions to every rule, especially when the rules are vague and subject to interpretation. The key is understanding how Section 1031 has been interpreted and how to put yourself in the best position for success.

Choosing a 1031 Exchange Qualified Intermediary

Many rules related to 1031 exchanges aren’t set in stone. This can make things difficult because there’s no cut-and-dry answer to a lot of questions, but it also means that there are always exceptions. And if you want to do something that feels like it may be on the borderline of what is allowed, there are things you can do to make success more likely, such as holding a property for two years as a rental property before selling it in an exchange.

Every exchange needs a Qualified Intermediary (QI) to manage the sales proceeds during the exchange process so you don’t take receipt of the funds until the exchange is over. If you’re executing a complex transaction like an improvement exchange, it’s vital that your QI understands these rules and follows the law so that your exchange isn’t disallowed. Choosing the right 1031 exchange qualified intermediary is especially important when the transaction involves rehab work, timing requirements, and questions around investment intent. That’s the value of a seasoned QI like JTC: we have experience with all types of exchanges, and provide the same high-level service to all of our clients. We can work with you to determine the right strategy for your exchange.

The benefits of an experienced QI