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New Study Shows Real Estate “Flippers” (Traders) Doing Very Well

A study released by First American Real Estate Solutions, an Anaheim (CA) data provider, found that the practice of flipping real estate can pay big returns.

(The study looked at sales in three hot markets—Las Vegas, Miami, and Orange County, California—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.)

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.

However, according to some tax experts, the trouble is that people don’t understand the rules and therefore many trust the advice of real-estate brokers, who often aren’t well versed in tax law. Also 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.

Novice real-estate speculators who attempt to flip properties should be certain they understand the rules. The best way to avoid a problem is to consult a CPA or tax attorney before beginning the real-estate transaction.

The problem or mistake for novices 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.

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 trade an investment property for a personal asset, such as a primary residence or a vacation home.)

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, wherein a seller has 45 days to identify a replacement property and 180 days to close on the new asset.

Aside from like-kind exchanges, remember that you must also hold your 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%.

And you can avoid the capital-gains tax altogether if you own and use your 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.