1031 Exchange: Rehab for Rental?

Question

Has anybody done this and/or is it possible?

I'm back and forth between rehabbing and purchasing rentals (I mainly rehab to get additional capital for purchasing rentals) and am wondering if the "like kind" clause around 1031 exchanges is flexible enough to allow me to 1031 my profits from a rehab into a rental property.

Steve Babiak · Answer

Jon Klaus - all good questions, and probably no really clear answers. To try to give a clear answer, if the property needs rehab, but you do not rehab but just hold it a year and then sell - that could probably be justified as investment rather than inventory, especially if you aren't already categorized as a dealer. As with other types of investments (say stocks), you sold the investment when a profit was presented to you. If it can be classified as investment, then income / profit falls under capital gains. Once you start the rehab, and sell within a short time, then it more likely will appear as inventory rather than investment; this is more of a gray area than the first scenario I outlined - you might reasonably be able to justify that this was not inventory if your past dealings were all held rather than just sold, and this one sale for profit is just an anomaly rather than the pattern.

Jon Holdman · Answer

Its still ordinary income. Fix and flips are ordinary income. Period. Now if you rehab a house, turn it into a rental for a year, and then sell it, it would be long term capital gains. Ordinary income is added on top of any other ordinary income. So it gets taxed at your current marginal tax rate. Some of the income could be taxed at a higher rate, if it pushes you into a higher tax bracket. Ordinary income is also subject to SET (self employment tax). That's medicare plus social security. Since that's self employment income, you pay both halves. That said, if you have a day job, you may be pushing up toward the cap on Social Security, so this might not be a big deal. Short term capital gains is at the same tax rate as your ordinary income, but its not subject to SET. That would be, for example, if you bought a stock and sold it for a profit in less than a year. You would pay short term capital gains tax on that, but not SET. Long term capital gains is at a lower rate. Currently 15%. No SET, either. A rental, for instance, bought, rented and held for more than a year and sold at a profit would be subject to long term capital gains. So would a stock held over a year. Short term capital gains for real estate gets trickier. If you bought a rental, got it rented, then had an offer you couldn't refuse to sell it for a profit after six months, you may be OK. Especially if you have a portfolio of rentals. OTOH if most of your business is fix and flipping, but you have someone who despartely needs short term housing and you rent them a house for a few months and then sell it, it might still be considered a fix and flip and treated as ordinary income and subject to SET. Fix and flipping is just the same as running a manufacturing business. You buy raw materials (junky houses and building materials). You manufacture a product (pretty houses). You have labor costs and overhead. The houses that are ready to sell are inventory and the flips that are being done are work in progress. Same as if you were buying parts and building cars.

Steve Babiak · Answer

I agree with Jon Holdman that what Jodi Melssen did will not stand up in an audit; if there is no audit then that might not matter ... Now, if Michael Siekerka does a rehab that is subsequently rented, then sells that property after it was a rental - that scenario would become eligible to be considered as a relinquished property for a 1031 exchange IMO, because that rehabbed rental property was not inventory, it was an investment. According to the 1031 attorney specialist that I speak with from my area, it is even possible to structure a lease option to be the relinquished property in a 1031 exchange; I would suggest that if you want to get that creative that you consult an attorney who specializes in 1031 matters.

Wayne Brooks · Answer

Nope, long term investments/cap gain situations only.

Steven Hamilton II · Answer

Michael Siekerka, No you cannot do that. Please ignore what Jodi Melssen stated as a flipped property unless it was held for investment does not qualify. You will argue that flipping it is an investment. However, it is not, it is business income. We discussed in another thread that her 1031 should not have been allowed. She had an intermediary and attorney that were not very experienced with exchanges. Jodi, It also tells me that your CPA is not necessarily very familiar with the rules regarding real estate transactions. The scenario of renting to hold it longer does not change the fact it was a flip. In fact if it cash flowed positive then that income could be subject to SE tax. This is a reason why having designated corporations can sometimes cause problems when you change the characteristic of a transaction. Jon Holdman is correct. Self-Employment Tax (SE Tax) is one of the reasons many flippers utilize a corporation (S or C) Both have advantages and disadvantages. In that scenario, there would be no depreciation allowed as the house is inventory. You would include the rents as ordinary income on your schedule C or for your corporation and then you would deduct the typical expenses minus depreciation. Also the rental income would be subject to SE Tax. To clarify what Steve Babiak said about being classified as a dealer. That depends more upon each transaction rather than overall. This is where separate entities can help you. If you divide your operations that will help show what the transaction really was for. -Steven

Jodi M. · Answer

Thanks for the feedback on my post. I will have to check with my CPA (he is also my RE attorney) about correcting any problems. On a side note to that, if I only flip 1 house a year is it capital gains or ordinary income? I have 1 property that I intended to make a rental but ended up doing more work and creating more equity so I have decided to sell it. I held it an extra couple months (while rented out) to qualify for short term gains vs long term gains. I think my ordinary income tax is the same as long term gains so if it's not going to be considered capital gains would I have any reason to keep it for a year(or longer)? Thanks

Jon Klaus · Answer

What if the rehab property is held for over a year (never rented)? Two years? Intent, right? What if the intent all along is the highest and best use or disposition? Letting the market tell you if it's a short term or long term hold?

Michael Seeker · Answer

Thanks for the feedback guys, much appreciated!

Jon Holdman · Answer

No, you cannot 1031 profits from a rehab into a rental. Rental to rental, yes. But rehabs are not "investments". They're inventory. They're not even subject to short term capital gains tax. They're just ordinary income and subject to SET also. What you did, Jodi Melssen is a clear violation of the requirements for a 1031. If I were you, I would amend your tax returns to correct this, and pay the taxes and penalties now rather than risking getting it discovered during an audit. Your CPA is being agressive to the point of being over a pretty clear line. I'll pull in our resident CPA Steven Hamilton II and 1031 expert Bill Exeter in case I've full of it.

Jodi M. · Answer

We are new at this but we did use a 1031 on our first fix and flip house last year. Since we're new I can't be 100% sure we did everything right (although it didn't cause any red flags at tax time) but with the help of our title company and CPA we did use a 1031 exchange to purchase rentals. We bought a house in the spring spent five months rehabbing it and sold it. Instead of taking the profit we did a 1031 and bought 3 new properties which are currently rentals. We were told as long as we identified and closed within the correct time frame it would work and the gains would be defered. We also wanted some of the profit to put toward other things so our loan officer then wrote a loan against one of the properites and was able to give us some of the profit to use as we wanted. Talking to investors in our area not many have used a 1031 regularly so I had to rely on my atterney on where to start and who to call.