According to real estate research company ATTOM, home flipping rates were strong during Q2 2021 (the most recent data available). Specifically, ATTOM’s researchers indicated that flipping transactions represented just under 5% of all home sales during the quarter, breaking out to approximately one in 20 transactions.
While the research also demonstrated that profit margins decreased on home flipping, it seems as though increasing home prices, combined with continued somewhat scarce supply, is bringing more flippers into the market. More flippers means more questions. And one of those questions is whether flippers of single-family rental properties can use the like-kind exchange to defer capital gains taxes.
The answer to this is a hard “no.” The reason? In the eyes of the IRS, there is a big difference between property held for resale, and property held for investment.
Flipping occurs when an investor buys real property, holds onto it for a short time, then sells it with an eye toward making a profit off of it. During the hold, the investor will likely invest capital into the real estate, in an effort to increase value. Under this definition, just about any kind of real estate qualifies for flipping, but the process is most often discussed in connection with single-family homes.
Through flipping, the investor doesn’t live or operate within a property. And in many ways, the process could be considered an investment. It’s just not the type of investment consistent with a 1031 exchange.
Internal Revenue Code Section 1031(a)(2) explains it pretty clearly. Specifically, property that is “held primarily for sale” doesn’t qualify for 1031 exchange benefits. This is because it doesn’t meet the IRS like-kind exchange criteria of “held for trade or investment.”
In most cases, real estate flipping focuses on quick resales, rather than longer-term holds. As such, “intent” plays a huge role when it comes to flipping versus a like-kind-exchange-qualified investment. Some of the factors the IRS studies to determine this intent includes:
When it comes to real estate flipping, the investor’s focus involves buying, improving, and selling, meaning more time is devoted to renovations and finding new buyers. This isn’t necessarily the case with a 1031 exchange investor. Again, the code is very specific, in that the properties being exchanged are used for trade (such as a place of business) or investment (suggesting a long-term hold and rental income). Properties held for “stock in trade” or resale simply don’t qualify for like-kind exchanges.
Finally, the IRS provides very specific safe harbor guidance when it comes to 1031 exchanges, none of which really matches the intent of real estate flipping. When it comes to both the relinquished and replacement properties:
Other safe harbor guidelines focus on Qualified Intermediaries, escrow accounts, security arrangements and interest/growth factors.
As such, when it comes to real estate flipping and 1031 exchanges, these two activities are incompatible. They have different investment purposes, adhere to different processes, and generally follow different hold periods.