rehab sell reinvest profits?

Question

Have a question I can't find an answer to. I just bought a house that I am planning to rehab and sell and hopefully profit enough to pay cash for another with those profits and then rent the second one. This is not my residence. I am wondering if I can avoid capital gains by reinvesting the money in a "like kind trade" by buying a house with this money and then renting it out. (so I can pay cash for it to avoid a bank loan)

Thanks.

Bill Exeter · Answer

I hear the argument that you are making all the time, but if you study case law involving tax-deferred exchanges you will see that intent to hold is applied property by property and not over a string of properties, otherwise your argument would apply to true fix-up an flipping, condo conversions, etc.  We have many clients that still exchange under your argument, but they are taking a risk no matter how they argue their position.  Sorry.

Bill Exeter · Answer

You are most welcome.

N/A N/A · Answer

Are you guys selling these houses yourself(fsbo) or using an agent?  Seems cost of using an agent cuts mightly into your profits.  But w/o an agent it could take a while to sell something you wanted to flip.

Lynn Z · Answer

It seems if one rehabs a replacement property and sells it to continue the equity that results in a 1031 exchange that that isn't "flipping" -- since the purpose is not to take the money and cash out but "hold for investment".  If the replacement property is sold and one takes the profit as cash I can understand that as a good example of not "holding for investment" but according to my tax guys you can rehab and roll into another investment which you might hold for many years as long as you meet all of the parameters of a qualified exchange.    Has anyone been involved where they sold their replacement property and rolled into an equal or greater value investment?  I would love some input on this.

Bill Exeter · Answer

Yes, investors do this all the time, but they are taking a risk in that the IRS could disallow the tax-deferred exchange because they are really holding for sale and not holding for investment.  There has not been any definitive guidelines provided by either the IRS or the courts, so it is a huge gray area.  There will always be a degree of risk until we have some type of substantive ruling to rely on.

Congress was considering a 12 month holding requirement about 13 or 14 years ago, but it never made it out of the committee.  We also know that the administration has been toying with the idea of 12 or 24 months, so anyone that is not acquiring with the intent to hold is taking some degree of risk.

Lynn Z · Answer

My point is you are "holding" if you continue the original investment without receiving any cash....you're just continuing the investment as opposed to  having intent to "cash out" by a  "sale".  You'd have to distinguish a closing as an exchange vs. a sale.  Common sense seems to cry out that a sale involves receipt of "cash" (equity) and I understand why the IRS would not want a "sale" but if you continue to roll into an equal or greater FMV investment,  you really haven't altered the basic nature of the investment.
I'm sure greater minds than mine have spent much time deliberating this issue.

Bill Exeter · Answer

The comments apply to all properties involved in a 1031 Exchange.  It would apply to any property that you have owned and held as investment property (i.e. your relinquished property must have been held for investment and not for sale) and would apply to any acquired like-kind replacement property (i.e. you must have the intent to acquire and hold for investment and not hold for sale such as fix-up an flip).

There is a great deal of gray areas in the 1031 exchange arena, and the holding requirement is certainly one of them.  The IRS and the courts have never clearly defined intent to hold for investment, so we do know that if you hold for investment and treat it as investment for 12 months or more you are absolutely safe.  It does not mean that if you hold it for less than 12 months that it will not qualify; it just makes it more difficult to prove that you had the intent to hold for investment.

Investors must look at each transaction and make a risk assessment as to whether they want to attempt a 1031 exchange, especially in fix-up and flip strategies.  There are many investors who are blatant flippers and still structure each and every transaction as a like-kind exchange.  It all depends on how concervative or aggressive you want to be.

Joey B. · Answer

Thanks for your info.  I learned more through this thread then I did the last six months trying to hunt for people that have a clue what the guidlines are.   It never occured to me that there were forums for real estate just like cars or anything else.     8)

Joey B. · Answer

Thanks, thats good info, but I'm not sure if those guidelines are refering to the first property or the second.   I'll try to make my situation a little more clear.

I own and have a loan on the house I live in.  I also own and have a loan on a rental property.  Then I have a third property that I just purchased with cash, but the cash came from two credit cards via direct deposit into my checking account at 2% interest for a 6 month time period.  (this is how I bought my first rental and then after I fixed it up I got a mortgage on it)  With the house I just purchased I would like to rehab it, sell it, and put the profits directly into another house for the purpose of long term rental simply for the purposes of avoiding a bank loan and having the debt on my income ratio.  If possible I would like to keep repeating this procedure. (buy, rehab, sell, invest in long term rental)

Thanks   :wink:

Bill Exeter · Answer

Your real intent sounds like it is to buy, fix-up, and then flip as quickly as you can, which means that your real intent is to hold for sale and not investment.  This will not technically qualify for 1031 exchange treatment.  Here is a more indepth explanation regarding holding requirements that I copied from our website:

1031 Exchange Holding Guidelines for Like-Kind Replacement Property

While the Department of the Treasury Regulations and numerous rulings make it very clear that the Investor must have the intent to hold his property for rental, investment or use in a trade or business, they fail to define exactly how long an Investor needs to hold his relinquished or replacement property in order to qualify for a tax-deferred like-kind exchange pursuant to Section 1031 of the Internal Revenue Code or Section 1.1031 of the Treasury Regulations.

If the Investor’s relinquished property was purchased just before the tax-deferred like-kind exchange transaction, the Internal Revenue Service has routinely taken the position that the Investor actually purchased the property for sale (investory) rather than holding it for investment.  Further, the Internal Revenue Service has also taken the position that if the replacement property is sold immediately after the tax-deferred like-kind exchange transaction then it was not held sufficiently long enough to qualify for tax-deferred like-kind exchange treatment.

While there is little definitive authority on the holding period, in one private letter ruling, the Internal Revenue Service has stated that a minimum holding period of two (2) years would be sufficient to meet the Qualified Use test, and a number of court decisions have been handed down that have also taken the same position (although they have been somewhat more liberal than the Department of the Treasury and the Internal Revenue Service).

The amount of time an Investor holds the property is not the only factor the Internal Revenue Service will use to determine whether the Investor had the appropriate intent to qualify for a tax-deferred like-kind exchange, but it is extremely important.

The easiest way to demonstrate the Investor’s intent to hold a property is to do just that:  actually hold the property as rental, investment or for use in the Investor's trade or business. The longer the Investor holds the property the stronger his case will be if the Internal Revenue Service questions the sufficiency of the Investors intent.

Tax advisors frequently recommend that Investors hold the subject property for at least one (1) year to prove intent.  Holding the property for at least one year will straddle two income tax periods and give the Investor two income tax returns listing rental income, expenses and depreciation, all of which help to provide a solid argument that the Investor had the appropriate intent to hold the property for rental, investment or use in his trade or business.

In addition, the United States Congress at one time considered a minimum holding requirement of 12 months for both relinquished and replacement properties. While the requirement was never enacted by Congress, it does provide a good indication of what sort of holding period Congress would consider sufficient to meet 1031 exchange requirements.

If the Investor is considered a “dealer”, he will typically not qualify for tax-deferred like-kind exchange treatment because technically the property is being held for sale as “inventory” and thus is not property held for investment purposes.  In some cases, however, dealers may be able to qualify for tax-deferred like-kind exchange treatment by segregating assets intended to be held as rental, investment or productive use in a trade or business from those assets being held for sale.  In these situations, some legal advisors have advised their clients to form a separate entity, such as a limited liability company, specifically to hold title to the segregated property in order to more easily qualify for tax-deferred like-kind exchange treatment in the future.

If however the Investor or dealer’s intent is to buy, fix up and then sell (“Flip”) the property, then he clearly does not have the intent to hold the property for investment purposes. Rather, the intent is to hold the property for sale, and accordingly does not meet the Qualified Use test and will not qualify for tax-deferred like-kind exchange treatment.

The holding issue becomes substantially more complicated when the Investor either holds legal title to the relinquished property, or intends to hold legal title to his replacement property in a partnership, corporation or multi-member limited liability company.   The partnership, corporation or multi-member limited liability company can certainly sell relinquished property held in the entity’s name and then purchase like-kind replacement property to be held by the same entity and still qualify for tax-deferred like-kind exchange treatment.  The difficulties arise when some of the underlying shareholders, partners or members of the multi-member entity wish to go separate ways and attempt to exchange their interests in that entity as part of a tax-deferred like-kind exchange.  If you own property in such an entity, you should seek professional assistance now in order to have time to prepare for a tax-deferred like-kind exchange transaction.

Only the Investor can determine how aggressive or conservative he wants to be in structuring and undertaking a tax-deferred like-kind exchange.   The longer an Investor holds a property prior to an exchange, the more conservative the course of action is and the easier it will be to prove the Investor has satisfied the Qualified Intent requirement. Conversely, the shorter the holding period, the more aggressive the transaction is considered and the more difficult it will be to demonstrate that the Investor’s intent was to hold the property for rental, investment or use in a trade or business.[/b]