Real-Estate Flip Deals Have a Catch

By: Colleen DeBaise: The Wall Street Journal Online
Amateur "flippers" in the real-estate market have more to worry about than a bubble. Many of them could be facing an income-tax audit - and higher tax bills than expected.

The popularity of so-called flip deals has made section 1031 of the Internal Revenue Code popular with real-estate speculators. In a 1031 exchange - also known as a "like-kind" exchange - a person who sells a business or investment property can defer capital-gains taxes by immediately rolling the gains into a similar piece of property.

The trouble, tax experts say, is that people don't understand the rules. Many trust the advice of real-estate brokers, who often aren't well versed in tax law. Some amateurs are buying and selling properties too quickly, running the risk that the Internal Revenue Service may deem the transactions a person's trade or business, with gains taxed as ordinary income and subject to self-employment taxes.

Flipping's attractions are undeniable: A study released this week by First American Real Estate Solutions, an Anaheim, Calif., data provider, found that the practice can reap big returns. The study looked at sales in three hot markets - Las Vegas, Miami, and Orange County, Calif. - between 1999 and June 2005 and found that the annualized rate of return for three-to-six-month flips was usually 20% to 40% or more above the market appreciation rate.

While flip sales didn't dominate the market in any of the three counties First American studied, they did account for as much as half of all sales within particular ZIP codes. In the Las Vegas area, properties turned over within two years accounted for 52.3% of total sales in ZIP code 89119 and for 45.7% of total sales in ZIP code 89147 during the first half of this year. And in the Miami area's ZIP code 33150, flip sales accounted for 41.7% of total sales last year and 43.6% of total sales in the first half of this year.

Novice real-estate speculators who attempt to flip properties should make sure they understand the rules before they are ensnared in an audit, or forced to pay more than they bargained for come tax season. The best way to avoid a problem is to consult a CPA or tax attorney before beginning the real-estate transaction, as mistakes can be costly.

"The IRS hasn't looked at the like-kind exchange before," says Eric Kea, a tax partner in the real-estate practice at BDO Seidman in New York. "We're assuming they're going to, seeing what the market is."

An IRS spokesman wouldn't speculate on whether the IRS will investigate or conduct more audits of like-kind exchanges. In general, the agency dedicates more resources if there are concerns of noncompliance in a particular area, the spokesman said.

In a like-kind exchange, if you replace a property used for business or investment with a similar property, no gain or loss is recognized at that time. Most people do a "deferred" like-kind exchange, where a seller has 45 days to identify a replacement property and 180 days to close on the new asset.

The big mistake for novices, tax experts say, occurs when the seller takes possession of the cash proceeds of the sale. Under IRS rules, the money must be placed in escrow or held by a qualified intermediary (such as a trust company) until the replacement property is acquired. "If you take possession, you are essentially disallowed the use of 1031," says Lonnie Davis, a certified public accountant and director of CBIZ Accounting, Tax & Advisory Services in Plymouth Meeting, Pa.

To avoid taxes, you have to roll the proceeds into a similar property, which generally would be a business property or raw or developed land. You can't swap an investment property for a personal asset, such as a primary residence or a vacation home, Mr. Davis says.

In a like-kind transaction, real estate must be exchanged for real estate, a rule that sometimes trips up clients who have set up a single entity to hold property and shield them from liability. Often, experts recommend that clients liquidate the entity a day before the real-estate transaction so the swap qualifies for 1031 treatment.

Apart from problems with the like-kind exchanges, there are other common mistakes that amateur investors make. One is not holding the property long enough. You must keep the investment for at least a year before selling to qualify for the preferential 15% capital-gains tax rate. If you sell before a year, the gain is subject to the highest income-tax rate of 35%.

You can avoid the capital-gains tax altogether if you own and use the home as your primary residence for two years. Gains of as much as $250,000 for an individual and $500,000 for a married couple filing jointly are excluded. The two years doesn't necessarily have to be continuous, as long as you have used it as a primary residence for a total of two years within a five-year period, ending on the date you sell the property.

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