Paying off additional expenses after a 1031 exchange?

Question

We are about to sell a house that is a flip/construction project--it's a total rehab and we've added a significant addition to the property, so we will have held it somewhere between 9-11 months and have not lived in the property. Initially we thought we could not use a 1031 exchange on a short-term flip, but with the extended timeline, our title company says that we can. This is our first flip in a while, so they don't think we will be considered dealers. However, we put a significant down payment on the property and have paid for holding costs and some materials out of pocket/outside of the construction loan. My understanding is that all proceeds from the sale must go into the 1031 escrow account, other than liens on the house itself, so that we cannot recoup the down payment, holding costs or pay off materials on a credit card. Are there any other ways to pay off those things? Should we ask our builder to put an additional lien on the property to cover "cost overruns" and then have them reimburse us for the materials that we paid for out-of-pocket? I'm assuming I won't be able to get a home equity loan on a construction project that is nearing completion with a one-year construction loan in place.

Dave Foster · Answer

@Sarah Lorenz, There is no statutory holding period. The standard is your intent. In order to do a 1031 exchange your intent must have been to hold the property for productive use in business trade or investment. Purchasing (or building primarily for resale does not qualify). In past times there was a great deal of comfort in doing a 1031 once the one year mark has passed. Most thought that the simple act of holding that period was ample evidence of intent. In recent years the irs has shown more willingness to ignore the length of time as the be all end all standard for demonstrating intent. In your case, youve got a bigger hurdle in that it's really not saleable right now and you will be selling it as soon as it is. So the 8-11 months becomes even more irrelevant.

Your title company is probably relying on the wording of a past tax case where the phrase "two tax years" was used as an appropriate length of time in that particular case. This does not mean that your's is automatically safe. You need to ask yourself what your intent was and how you could demonstrate that (past history, correspondence, stated, attempts to rent, extraordinary gain offered etc)

The cleanest way to recoup those costs would be to complete your exchange and then refi the new property and pull cash out to reimburse yourself. You don't want to add additional financing right before the sale as that could easily be perceived as an attempt to pull profit out of the deal. Your proposal with your builder is transparent but awfully collusive. It would probably go unnoticed but would be hard to explain if ever challenged. It would have been much better for them to have paid for those materials themselves and then billed as part of the construction contract. I'm sure it's been done but I couldn't recommend it.

Jacob Anderson · Answer

@Dave Foster That was some great info. Thanks

Paying off additional expenses after a 1031 exchange?

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