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The Truth about Taxes and Your Fix and Flip Business

by Amanda Han on July 10, 2014 · 22 comments

  
The Truth about Taxes and Your Fix and Flip Business

During the past few months I have seen quite a few blogs, posts, and comments about how taxes are assessed on fix and flip properties. There seems to be a lot of confusion and conflicting information so I wanted to use my blog this week to focus on some of the basics of how fix and flip properties are treated for tax purposes.

To start off, it is important to note what exactly a fix and flip property is. If you are an investor who is in the business of purchasing properties, rehabbing them and then selling it quickly for a profit, then this may fall under the fix and flip definition. With a flipper, the intent of the investor is to buy, improve, and quickly sell a property or properties. In the eyes of the IRS, this is treated as an active business and has the same tax treatment as if you were in the business of buying and selling cars for a living.

The downside of flipping for tax purposes is that higher taxes are frequently associated with flipping income as compared to rental income. Here are a few of the major downsides tax-wise of flipping:

1. No Capital Gains Treatment

If a  flipping transaction is considered active income, there is no long term capital gains tax treatment, even if you have owned the property longer than a year from the purchase date to the sale date.

2. No 1031 Exchange

When we own rentals, one of the greatest tax deferral techniques that we often use is the 1031 exchange. The 1031 exchange allows us to sell a property for a gain and defer the associated taxes, provided that we roll the funds into another investment property. However, since flipping is not considered an investment activity to begin with, there is no 1031 exchange that can be used with respect to flipping activities, even if all the proceeds were re-invested back into another flip.

3. Payroll or Self-Employment Taxes

If a flipping transaction is treated as an active income, it means that the person actively involved in the deal may also be subject to payroll or self-employment taxes. This is accrued by flippers the same way it is accrued by those who work a W-2 for a living or maybe a realtor who makes commissions income via a 1099. Fortunately, with the correct legal entity structures, a significant portion of the payroll/self-employment tax may be avoided.

Related: Investors Beware: 8 Warning Signs You May be Overpaying Your Taxes

What Can Be Done?

As you can see, there are quite a few tax pitfalls when a transaction is considered a flip. From a strategic planning perspective, it is important to clearly understand what defines a flip transaction and what can be done to avoid this designation.

Luckily for investors, the IRS does not have a strict set of guidelines to define what constitutes a flip transaction. For example, there is no court case that says “if you flip 3 or more properties then you are deemed to be a flipper and if you flip less than 3 properties you are ok”.  In fact, the Tax Courts make their determination on a property by property basis.

This means that one taxpayer can be deemed to be a flipper with respect to one property and not a flipper on other properties that he sells during the year. In fact, one taxpayer sold several properties in a particular year and of the handful that he sold, only 2 of them were deemed to be “flips” and the rest were allowed as investment properties eligible for the capital gains treatment.

If you are wondering how this could happen, the answer is simply that the determination of each transaction is based on its own set of facts and circumstances. One property may have a very different set of facts and circumstances from the next and in these cases, even if the investor is the same person, those two transactions can have very different tax treatments.

One of the most powerful facts that can work in your favor if you are looking to avoid the flipper designation is the word intent. What your intentions are with respect to a transaction can have a significant impact in terms of how much you pay in taxes.

Related: I Like Paying My Taxes (You Might, Too, After Reading This!)

For example, I had a client who purchased a property, rehabbed it, and sold it all within a 4 month period. On the face of it, this looks to be a flip transaction right? Well, not so fast.  For this particular taxpayer, his intent going into the property was actually to rehab it and hold it out as a long term rental.

In fact, even before the property was fully rehabbed, he already listed it for rent and people started to come by to view the property before it was ready. As luck would have it, one of the people who came to preview the property made an offer to purchase the property. Even though it was the taxpayer’s intent to keep it as a long term rental, this unanticipated offer to purchase it was too good to pass up and he decided to sell it right after the rehab was complete.

In this scenario, even though it was purchased, rehabbed, and sold in just a few short months, his intent with respect to this transaction was that of an investment and not of a flip and as such, he was able to get all the preferential tax treatments as an investment transaction. Since he ultimately decided to reinvest the proceeds back into another long term rental, he was able to use 1031 exchange to roll all the profit into the replacement rental property he later purchased and therefore paid zero tax the year this first unit was sold.

As with most things in taxes, the law can often be complex. Sometimes the complexities work to your advantage and other times it takes a little more digging into.

Do you have any stories where you had a big win with taxes?

Be sure to leave your comments below!

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{ 22 comments… read them below or add one }

Engelo Rumora July 10, 2014 at 4:13 pm

Thanks for sharing Amanda.

Your blog offered some great insights.

Thanks and have a great day.

Reply

Amanda Han July 14, 2014 at 6:19 pm

Thanks for reading Engelo!

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Eric July 10, 2014 at 4:38 pm

I have one flip from earlier this year. I generally do not do flips, but this one was a no-brainer. I am still a bit worried about the taxes…

Reply

Amanda Han July 14, 2014 at 6:20 pm

Eric:

The year is not over yet so if you are worried about potentially paying high taxes, now is the time to meet with your CPA To go over what strategies may be good for you.

Reply

GK Banchero July 10, 2014 at 9:49 pm

Thank you! This is such a confusing topic.

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Amanda Han July 14, 2014 at 6:21 pm

Thanks GK….it seems like everything taxes is confusing and getting even more so by the day. Hopefully this helped to clarify things a bit for you =)

Reply

Regina July 11, 2014 at 12:33 am

Thanks for sharing this article..

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Amanda Han July 14, 2014 at 6:21 pm

Thanks for reading Regina!

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James July 11, 2014 at 7:16 am

Hi Amanda

Isn’t 1031 is only allowed after you keep the properties for more than 2 years?

James

Reply

Amanda Han July 14, 2014 at 6:22 pm

Hi James:

No a 1031x is available for “investment” properties. So if the property meets the qualification as a rental property, then you can use 1031x even if its rented for a year.

Reply

Isaias Arroyo July 11, 2014 at 12:57 pm

Great article Amanda, I always enjoy your articles.
It’s great that your client at least has the evidence to to back up his intent.
That’s not always the case, I always remind my clients of how nice the IRS is when you show up to an audit with no proof. They get the point…

Reply

Amanda Han July 14, 2014 at 6:23 pm

Thanks Isaias! Yes…documentation is KEY to surviving an audit.

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Jessica S. July 13, 2014 at 9:03 am

Hi Amanda,
Thanks for contributing this blog post, it’s very helpful. When I flip houses I normally designate the proceeds as self-employment income. However, this year I ran into a different situation: I bought a house with the intention of rehabbing it but ended up selling it to a developer without making any improvements to the property. Could the net proceeds from this be categorized as investment income? And can I add the fixed costs associated with holding the property for four months to the cost basis?
I’d love to hear what you have to say on this one. Thanks!

Reply

Amanda Han July 14, 2014 at 6:25 pm

Hi Jessica-sounds like this was more of a wholesale deal since you didnt make any improvements? How it is treated depends on your intent…so if intent was for it to be a wholesale/flip then it will still be treated as such. However if the intent was for it to be a rental and you got an unexpected offer, then you may have an argument for investment income. In either case…your holding costs can reduce the taxes from the gain.

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Ed Castellanos July 13, 2014 at 12:44 pm

Thank you for this helpful blog post.

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Amanda Han July 14, 2014 at 6:25 pm

thanks for reading Ed!

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Shaun July 14, 2014 at 12:30 am

My intent is always to keep the property, if someone will give me enough rent to actually cash flow.
Unfortunately most SFH around here won’t cash flow well. Buy a place rehab it and have a projected monthly cost of $2200 but can only rent it for $1800, not a good one to keep.
Oh but I can sell it for a $35K profit, phew dodged a bullet there!
Now I will just take that seed money and get a place that will actually make me money every month.

Reply

Amanda Han July 14, 2014 at 6:27 pm

thanks for your comment Shaun =)

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Bo Wagner July 14, 2014 at 8:38 am

First off, I am not a CPA or a tax attorney but a few things to toss into the mix–here in GA, if you sell a property and are not a GA resident (or don’t have a GA entity) you may be liable for a 3% tax on the proceeds (if there is a gain over $20,000). Likewise, with all the foreign investors kicking tires in US real estate, it would be wise for them to check into FIRPTA and whether or not that Federal 10% tax will apply to them (a tax for people not taxed as US-citizens). Just a few more to think about! Bo

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Amanda Han July 14, 2014 at 6:26 pm

Thanks Bo. Yes in CA we also have a withholding tax on certain real estate sales that sometimes can “surprise” an un-expecting investor.

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Steve July 14, 2014 at 6:57 pm

Great article. But really, basing the tax owed on intent… just proves that we are long overdue for extensive tax reform. Oh, and can I argue an audit based on my hard drive crashing?

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Amanda Han July 16, 2014 at 8:55 am

Thanks for your comment Steve. Yes tax reform is definitely needed. Keep in mind ” intent” is not a simple as stating it as such. You will want to be able to support that intent. An example would be if your intent is for a property to be an investment rental, then having an actual renter in there is ideal. Other ways that may be helpful would be advertising the rental, showing it, getting applicants, etc. etc. If we say the intent is a rental but all signs point to us trying to flip it immediately then that will not work in an audit.

Reply

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