rent to own 1031 exchange and mortgage

[Josh Dillingham]

In December I bought a single family home, all cash, which was in rough shape and had been vacant for over a year. I had the intent of fixing it up, renting it for a couple years then selling it. I have it advertised to rent now and I've got someone who is potentially interested in purchasing the house outright or doing a lease option. my questions are: 1.) if I sell it out right, only having owned it for 4 months will I get slammed with self employment tax and regular income tax and not be eligible for 1031 exchange. or could I still call it an investment property and be able to 1031 because my intent was to rent it? 2.) if I lease option it with a 2 year option will I be able to 1031, or not because my intent from the beginning of the lease option is to sell it? 3.) I don't currently have a mortgage on the house, if I set up a lease option would that stop me from taking out a mortgage so I can pull out my forced equity from all my improvements to the property so I can roll it over to a down payment for another investment? thanks! Josh Dillingham Brattleboro, vermont

[Clayton Mobley]

@Josh Dillingham I don't have as much experience with lease options, so I'll focus my response on the 1031 aspect.

So, yes, as you obviously know, a 1031 is dependent on the property being a long-term investment. HOWEVER, there isn't, legally speaking, any specific length of time that you have to hold the property. Yes, most people feel most comfortable with a year or more, but sometimes life happens. Sometimes a property purchased as a long-term investment ends up being a money pit, or the rental demand dries up in your market. There are a million reasons why a would-be long term investment can need to be unloaded early. For a 1031, the thing that matters is your intent, which you clearly state was to have this as a long term rental prop.

I would speak with one of the Qualified Intermediaries here on BP, like @Bill Exeter or @Dave Foster, to see specifically what you would need to do to demonstrate intent to the IRS. This wouldn't be something you can do regularly - the IRS catches on quick to people trying to use 1031s to flip prop after prop and pretending they intended to hold 6 consecutive props. So don't try to abuse the system (which obviously isn't your intent anyway). But one time may be ok IF you can adequately demonstrate your intent and the reason WHY you need to sell early. 

You don't give much detail about the situation other than that you have an offer. Have you already fixed it up? Are you having trouble renting? Four months isn't very long to rehab a prop and establish that finding a tenant is overly difficult. You'd likely need to be able to show the IRS that there is a viable reason that you need to get out of this investment so soon, other than just because someone offered to buy it - why would selling now be a more lucrative option than holding it?

Of course, I'm not promising you'll qualify for a 1031, but there's a slim ray of hope depending on the specifics of your situation (again, definitely contact a QI and ask). If not, then sadly yes, you'll likely get hit with allll the taxes. Of course, remember that you can include any major rehab or upgrades you've done in your tax basis. So if you bought it distressed for $50k and put $30k in work into it to make it habitable, your basis is $80k (not counting any taxes owed by the previous owner if you paid them, purchase costs like title expenses, etc). So depending on the current offer, your CG may not be as big as you think.

Hope some of that helps!

Clayton