I'm an idiot

[John McClain]

I recently sold a rental property with the intent of using the profits to begin buying flips. The proceeds from the rental sale went straight from title to the QI therefore I have already paid the exchange company their fee. I am just now finding out that I may not be able to exchange the funds into a property that I intend to flip. Will my profit be taxable if I use these funds to buy a flip rather than a long term rental?

[Bill Exeter]

I'm going to try to address all of the issues in one post.

Qualified Use and Like-Kind Requirements

There are two requirements regarding the type/use of the property. The first is that the relinquished property and the replacement properties must satisfy the Qualified Use requirement. Essentially, this means that you must have the intent to hold all of the properties involved in the 1031 Exchange for rental, investment or use in a business. The second is that the properties must be considered like-kind to each other. In the real estate context, any real property is like kind to any other real property as long as the Qualified Use test is met.

Properties acquired for rehab/flipping are acquired and held for sale and are not held for investment as that term is defined for 1031 Exchange purposes. Essentially, property acquired and held for flipping is considered inventory in your real estate business as opposed to actual real estate held for investment.

@Steve Babiak Steve raises an excellent point. Your Qualified Intermediary should have told you this if you told them that you intended to invest in rehab/flips. We always try to ask and "read between the lines" when talking with clients to try to catch things like this. Unfortunately, many Qualified Intermediaries are just processors and don't want to be put in a position of having to provide guidance. In my humble opinion, unless they had no clue that you were going to do rehab/flips, they should refund your 1031 Exchange fee.

@B Snouffer There are many states that require you to register/file with the state, county or city and pay a business license fee/tax in order to operate a rental property business. The real estate itself is still considered to be real estate for 1031 Exchange treatment purposes. Now, if you contribute the real estate into a corporation and then sell the stock, that is an entirely different thing.

@Jon Holdman is right. Section 1031 is a Federal code (U.S. Tax Code). The majority of states follow it exactly, while others follow most of it, and Pennsylvania is the only state that does not fully recognize any part of Section 1031.

You can always complete your 1031 Exchange, rehab the property, hold for rental for over 12 months, and then sell, but you are most likely straying from your business model, which is probably not a good thing to do.