1031 exchanges are a great tool that enable real estate investors to sell properties without paying taxes on the proceeds of the sales so long as they are immediately rolled into the purchase of a new property. After the completion of a sale, the gains are normally taxable, but when performing a 1031 exchange the sale proceeds are transferred to a third-party intermediary who holds the funds until they are transferred to the seller. Thus, on paper the real estate investor has never actually made any income from the initial sale and avoids paying taxes. This is useful when an investor has identified a property they think is a better long-term investment than the one they originally owned. 

In theory, if applied correctly 1031 exchanges will allow you to sell real estate over the course of your entire investing career and never pay taxes on those gains. It’s important to keep in mind that this strategy has strict requirements that you have to adhere to. Failure to abide by these rules can result not only in paying taxes on an individual transaction in question, but also on all previous transactions that were completed.

 

Flipping houses by its nature is quick and transactional. The intent is to own your investment properties for as little time possible, typically only a few months at a time. 1031 exchanges are more often intended for use with properties you intend to buy and hold on to for a longer time. There are time limits on identifying the property you’ll roll sale proceeds into when you’re looking to perform a 1031, issues of deciding who will be the intermediary that holds onto the money during the transaction (it cannot be someone with whom you have any formal business relationship), and a limited number of days to complete the subsequent transaction. These issues can make it very difficult to complete a successful exchange in the context of finding a new house to flip, and it’s easy to find yourself disqualified in this scenario and potentially subject to penalties.

 

For those reasons, you should limit yourself to using 1031 exchanges for development projects and longer-term buy-and-hold real estate investments, despite how tempting it may be to try to avoid paying taxes on the income from your house flips. But if you’re still intrigued by the possibilities as a house flipper, consider this longer-term strategy: Using the proceeds you make from your fix-and-flip projects over time, purchase a rental property. You can then use 1031 exchanges if and when you identify a property you want to trade up to as a stronger long-term investment opportunity, and sell your rental property without having to pay taxes on the proceeds.