Business Management

Will My Flips Qualify for Long-Term Capital Gains or Will I Need to Pay Self-Employment Tax?

Expertise: Business Management, Landlording & Rental Properties, Personal Finance, Personal Development
65 Articles Written

A question often presented on the BP Forums is whether or not flipping income is subject to self-employment taxes. The answers tend to range wildly in accuracy and completeness. For instance, some people think all flips are classified as inventory and subject to ordinary income rates and self-employment taxes. This is false (sometimes). On the other hand, people generally think that if you hold a flip for 12 months, you will avoid all of these nuances and simply pay long-term capital gains. Also false (sometimes).

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So what’s the truth? In classic CPA form: It depends, and what it really depends on is intent. The intent of the transaction determines how the proceeds will be taxed. If you are able to demonstrate "investment" intent, you will qualify for the preferred capital gains tax treatment. If you are unable to demonstrate investment intent, you will be tagged a "dealer," and the property will be classified as "inventory," with the proceeds being taxed at your ordinary rate plus self-employment tax, regardless of how long you actually hold the property (a 12 month rule for dealer versus investor does not exist).

It is very clear that, in terms of taxation, demonstrating investment intent will place you in an advantageous tax position.

I had a potential client call me the other week and ask me how I would classify his very clearly flipping activities. I told him that I would classify him as a flipper, as he has not shown investment intent. He pointed me to this article, which advises readers to fire their CPAs and “just go for it” if the CPA is classifying them as a dealer and reporting their flipping activity on Schedule C — Profit or Loss from Business versus Schedule E — Supplemental Income/Loss from Passive Activities. The writer of the article claims that reporting flipping activities on Schedule C “blatantly admits that he’s a dealer” and “increases chances for audit,” both of which are true facts. However, this article gave my potential client the understanding that flips should never be reported on Schedule C, which of course is false and can be attributed to tax evasion (illegal).

Again, it’s all about intent. Your intention is your business model and how you aim to make a profit. Are you actively buying and reselling property (a dealer) or are you buying and holding the property, making money each month off the net rental income and banking on appreciation (an investor)?


Factors to Be Considered

The US Tax Court, through litigation, has given us several factors to consider when determining the intent of a transaction. These factors are called the Winthrop factors and stem from the Tax Court case Bramblett v. Comr. 1992. The factors aim to determine whether or not an asset is a capital asset within the definition of Section 1221, which basically states that all assets are capital unless specifically excluded. Well, Section 1221(a)(1) specifically excludes real property being held primarily for sale to customers in the ordinary course of the trade or business from being considered a capital asset. These factors are:

  1. The nature and purpose of the acquisition of the property and the duration of the ownership;
  2. The extent and nature of the taxpayer’s efforts to sell the property;
  3. The number, extent, continuity and substantiality of the sales;
  4. The extent of subdividing, developing and improving the property that was done to increase sales;
  5. The use of a business office and advertising for the sale of the property;
  6. The character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and
  7. The time and effort the taxpayer actually devotes to the sale of the property.

In addition to the above, the 5th Circuit in Suburban Realty Co. v United States, 1980 laid out three relevant questions, which must be answered under the statutory framework by the application of the factors. These questions are:

  1. Was the taxpayer engaged in a trade or business, and if so, what was that trade or business?
  2. Was the taxpayer holding property primarily for sale in that business?
  3. Were the sales contemplated by the taxpayer “ordinary” in the course of that business?

With the combination of the Winthrop factors and the three additional questions addressed in Suburban, you would think we would have a good idea of how to analyze a particular situation. However, over the years, the courts have seemingly further muddied the water by sometimes ruling on only a few factors at a time or contradicting earlier rulings.

Related: The Tax Court Case That Proves You Can Qualify as a Real Estate Professional With Only One Rental


Methodology for Determining Intent

The methodology to determine intent rests with answering the three questions laid out by the Suburban case. While answering these questions, each of the Winthrop factors will be applied.

Additionally, in Biedenharn Realty Co., Inc. v Comr. 1976, the Court stated that the frequency of sales was the most important criteria, though also stated that “no one factor controls the outcome.” The Court stated that numerous dispositions of property over an extended period of time generally will be treated as ordinary gain. Conversely, when sales are few and isolated, the taxpayer’s claim to capital gain is more likely.

This ruling has also been backed up over the years by several other rulings such as Rice v Comr. 2009 and Wendell & Garrison v Comr. 2010, who have ruled that frequent and regular sales in tandem with development and improvement activity will usually result in ordinary gain/loss, rather than the favorable capital gain treatment.

Engaged in a Trade or Business

The Court in Suburban stated that a taxpayer engaged in frequent and substantial sales of real property is almost inevitably engaged in an active real estate trade or business and subject to ordinary rates. The Court also acknowledged that there is not “bright line” test to determine frequency or continuity of sales and is rather determined by a holistic look at the facts and circumstances surrounding the transaction.

Substantiality is also a major factor. In Suburban, the Court noted that 83% of the taxpayer’s gross income from all sources were derived from the taxpayer’s real estate sales. However, in Guardian Industries Corp. v Comr. 1991, it was noted that the income factor alone cannot provide a reasonable basis of substantiality, as a taxpayer who holds property for a long time may see a large amount of appreciation, and in the year of the sale, a large amount of income from the sale.

In Flood v Comr. 2012, the taxpayer whose day job was a “day trader” (a.k.a. unemployed) began buying up vacant lots, 250 in total. Over the course of two years, he subsequently sold 42 lots to customers. He did not improve nor did he intend to improve these lots. Yet the Court noted that the taxpayer’s “day trading” business was not earning money and therefore decided that the taxpayer’s primary job was the purchase and sale of land. To further support their findings, they noted that the taxpayer only sold his most valuable lots of land while keeping the rest. This resulted in a substantial amount of income from all sources stemming from his land sale activities. The taxpayer here was subject to ordinary gain treatment.

In Morley v Comr. 1986, the taxpayer whose normal job was a real estate broker purchased a large tract of land and immediately began solicitation to resell the property. The court determined that, while the taxpayer made no attempt to improve the land, he was engaged in the trade or business of selling real estate, and the profits from the sale of his land were subject to ordinary gain treatment. This ruling could have been because the taxpayer was already engaged in a trade or business of selling real property to clients — interesting to consider.

Your activities with the property will also support whether or not you are engaged in a trade or business. An investor will usually have a low amount of activity and wait for the value of the property to appreciate with time. On the other hand, a taxpayer engaged in the trade or business of developing, re-developing, and/or selling real estate will be actively working in that trade or business.

Holding a Property Primarily for Sale

The purpose of holding a property is demonstrated by the taxpayer’s motivation in holding the property prior to the sale. The original intent is generally established when a property is purchased but can change throughout the hold period. For instance, in Suburban, the court determined that the original intent was to hold the property for investment purposes, but then the property underwent substantial development and it was determined that the intent had changed.

In Byram v. Comr. 1983, The court noted that “…substantial and frequent sales activity, standing alone, has never been held to be automatically sufficient to trigger ordinary income treatment” and placed emphasis on four factors:

  1. The frequency and substantiality of sales,
  2. Development activities,
  3. Solicitation and advertising efforts, and
  4. Brokerage activities.

In Lewellen v. Comr., T.C. Memo 1981-581, the Court determined that the absence of sales “measures” (i.e. solicitation) would not necessarily qualify the taxpayer for the advantageous capital gains treatment. The Court reasoned that if the taxpayer has a solid reputation, the taxpayer likely engages in little-to-no solicitation, yet is still holding assets out for sale to customers in the course of his/her regular trade or business.

To contrast the above, the presence of sales measures does not necessarily bar capital gain treatment. In Chandler v. Comr.,  1955 the Court ruled that a taxpayer wishing to sell a capital asset is not required to sit idly by waiting for buyers to appear. Partaking in solicitation in this case did not bar the taxpayer from capital gains treatment.

For those of you who believe you can simply “hold the property for 12 months” to avoid your profits being subject to your ordinary rates, I encourage you to read Real Est. Corp., Inc. v. Comr. (1961), where the court ruled that while the taxpayer held the property for extended periods of time, the taxpayer maintained an intent to sell as soon as feasibly possible. Therefore, the asset was not held for investment intent.


Sales in the Ordinary Course of Business

Under Suburban, the determination of what is “ordinary in the course of business” is whether the sale was usual as opposed to an abnormal or unexpected event. If the taxpayer’s purpose in holding the property was primarily for sale to customers, an ordinary gain will ensue.

This is the interesting section as the investment can be structured in a way to avoid ordinary gain treatment. For example, in Yunker v Comr. 1958, the taxpayer inherited property and could not sell it without developing it. So the taxpayer partnered up with an agent, developed the property and sold it off over a two year period. The Court allowed long-term capital gain treatment declaring that "Where a taxpayer liquidates his real estate holdings in an orderly and businesslike manner, he is not by that circumstance held to have entered into the conduct of a business."

This is further supported by Heller Trust v Comr. 1967 Appealed, where two taxpayers entered into a partnership and developed a row of duplexes, only later finding out that they could not rent them for nearly what they originally thought. The partners got into a fight and began liquidating their investments to terminate the partnership. This liquidation was stretched over a four year period and the Court ruled that the sales were subject to long-term capital gains as this was the most efficient means of liquidating the partnership.

Another case supporting the above is Gangi v Comr. 1987. The taxpayer converted a 36-unit rental apartment building into condominiums and proceeded to sell the condominiums as a means of liquidating, in an orderly fashion, his investment. The Tax Court found that the taxpayer was entitled to treat the gains as long-term capital gains.

However, even if a taxpayer has clearly held property for investment purposes for an extended period of time and he/she begins to engage in subdivision activities, undertakes significant sales activities, and continues this process over an extended period of time, the previous “investment intent” will no longer be applicable and the taxpayer will lose capital gain treatment.

For example, in Biedenharn the Court of Appeals upheld the Service’s treatment of sales by the taxpayer as ordinary income despite the fact that the taxpayer had operated the property in question as farm land for an extended period of time. After that, the taxpayer decided to improve the land by adding streets, drainage and water lines, sewers, and electricity. The cost of the improvements was substantial and although the subdivided lots were sold over a period of approximately 30 years, the Court determined that the sales did not qualify for capital gain treatment.


Related: Accounting for House Flippers: Best Practices Investors Should Know

What Happens if You’re Classified as a Dealer?

If your transaction is classified as a dealer, the bad news is that the gains will be subject to self-employment taxes and your ordinary tax rates, but not all hope is lost.

Dealers can deduct all business expenses such as education, home office, vehicles, equipment, computers, meals, travel, etc. Investors may be limited to such deductions or barred from them in total.

Dealers can also contribute to retirement accounts as the income is “active” in nature rather than “passive” in nature. This allows dealers to strategically position themselves to build substantial, tax-deferred, long-term wealth. Dealers can also set up tax-advantageous benefits, such as health insurance, where they can deduct their premiums. Investors cannot do any of this.

Lastly, losses incurred by dealers are usually fully deductible whereas investors are limited by the Passive Activity Loss Limitations. While it isn’t ideal to lose money, this is nonetheless a benefit to being a dealer.


If you made it this far, pat yourself on the back. This was a long article citing technical authority which can sometimes be dry. But as you can see, classifying a transaction is not as simple as saying “all flips are inventory” or “hold for 12 months and you’ll be fine.” There is a heck of a lot more that goes in to the determination, and you should absolutely seek out a qualified professional for advice.

And in any case, don’t end up like this guy.

Flippers: Anything you’d add to the above? Have questions?

Be sure to leave a comment below!

Brandon Hall is a CPA and owner of The Real Estate CPA. Brandon assists investors with Tax Strategy through customized planning and
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    Adam Schneider Lender from Raleigh, NC
    Replied about 5 years ago
    Brandon, Absolutely outstanding article. Thank you.
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Thanks Adam!
    Clint Bolton Real Estate Broker from Hernando, MS
    Replied about 5 years ago
    Great article Brandon! That finally makes a lot more sense to me now after reading this. I’ve had discussions about this lately with my CPA and although it did help me understand the tax implications to flipping as a real estate broker, he did not cite all if these cases as you did here. That helped to better understand the MUDDINESS of the IRS tax code… I say let’s go with a 15% flat tax and then we can stop worrying about “what the investment looks like” struggle… Ha ha Thanks again! Your articles are usually very throrough and beneficial!
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Thanks for reading Clint – I’m glad I could clear things up for you!
    Jennifer Ryan Flipper/Rehabber from Arlington, TX
    Replied about 5 years ago
    Hi Brandon, My husband, a tax CPA, complimented your article and said it is dead on! Great article; informative, thorough, and interesting.
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Jennifer – thanks for reading and the kind words. That’s a heck of a compliment. Tell your husband thank you!
    Curtis Bidwell Rental Property Investor from Olympia, WA
    Replied about 5 years ago
    We always get it to trouble when a bureaucracy gets to determine “intent”! You said, “Dealers can deduct all business expenses … Investors may be limited … or barred from them in total.” My business is buy-and-hold. I rarely sell, and usually 1031 when I do. My income is derived from rents. Why would I be limited to what I can deduct? Or do I need to create a separate “management company” to properly benefit from the deductions?
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Hey Curtis – thanks for reading and posing this question. Generally, active landlords will have nearly the same capabilities of deducting expenses as that of a business owner. The business owner has the advantage of utilizing retirement accounts, health insurance, employee benefits, etc. whereas the active landlord will not. This stems from the business owner’s income being classified as “active” and the active landlord’s income being classified as “passive.”
    Doug W. Flipper/Rehabber from Alexandria, VA
    Replied about 5 years ago
    Great article. Thanks for all of the examples you cited. I don’t often see anyone mention that, per the IRS: “You can deduct the employer-equivalent portion of your self-employment tax in figuring your adjusted gross income.” It seems like that can add up to a nice deduction.
    Matthew Hurst from Gainesville, Florida
    Replied about 5 years ago
    You raise a good point. For anyone who is confused, I will summarize as follows. That deduction is intended to put the self-employed person in the same situation as a W-2 employee with equivalent income. The IRS assumes that a W-2 employee pays the employer’s side of FICA through lower wages, in addition to paying the employee portion directly. Therefore, the IRS makes self-employed people pay both sides, for a total of 15.3%. The employer’s portion of FICA / employment taxes is not included in the taxable income for the employee. For that reason, a self-employed person is able to deduct the employer-equivalent portion of the self-employment tax from his taxable income, so it is not included in his taxable income either. Example: W-2 employee earns $100,000. Total cost to his employer is $100k + 7.65% employer-portion, which equals $107,650. Yet the W-2 employee’s income for income tax purposes is $100,000, not $107,650. Self-employed person earns $107,650. He must pay both employer-equivalent and employee-equivalent portions of the employment taxes, for a total of 15.3%. That basically puts him in the same situation as a W-2 employee earning $100k. Half of that, or 7.65%, is the employer-equivalent portion. He gets to deduct that from his income, so that he also has taxable income of $100k. It gets a bit more complicated, but this is the basic rational for the employer-equivalent deduction for income tax purposes.
    sri ram
    Replied about 5 years ago
    Great article. Very informative and gives the investors the clear perspective how clasify your deals. thanks for taking the time to explain.
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Thanks Sri, I appreciate you reading and commenting!
    Account Closed Investor from San Jose, CA
    Replied about 5 years ago
    Brandon, Thanks for the article. I have a question for you. My partner and I are buy and hold investors. We got a good deal on an apartment building for $1.115MM. A couple of months after we bought it, someone offered to buy it from us for $1.5M before their 1031 exchange clock is running out. We declined. Given the fact that we “intent” to buy and hold, we would still be subject to short-term capital gains (basically ordinary income) although we don’t have to pay self employment tax correct? If we hold it for more than 1 year, then sell it, we would we subject to long-term capital gains, right? Regardless, the latter scenario is more tax advantageous compared to the first correct? Looking forward to your answer. Thx.
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Hey Minh – thanks for reading and great quetsion. Assuming you are able to demonstrate investment intent, if sold before 12 mo you would be subject to short term capital gains (taxed at your ordinary rate) but no SE tax. Hold longer than 12 mo and you will be subject to long term capital gains. Hope this helps!
    Account Closed Investor from San Jose, CA
    Replied about 5 years ago
    Thanks Brandon. Have a great holiday season sir.
    Ryan Landis Residential Real Estate Broker from San Mateo, California
    Replied about 5 years ago
    Really enjoyed the post Brandon!
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Thanks Ryan – I appreciate you reading and commenting!
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Thanks Ryan – I appreciate you reading and commenting!
    Matthew Hurst from Gainesville, Florida
    Replied about 5 years ago
    You may also want to mention that for anyone taxed as a real estate dealer, or any other business that earns money from both a mixture of labor and capital, they may be able to structure their activity as an S-corporation or an LLC taxed as an S-corporation. For those not familiar with taxation of S-corporations, it basically allows a person who both works and owns their own business to separate earned income from unearned income. Earned income – which results from their labor as an employee of their business is subject to both employment and income taxes. Business income results from their ownership in the business and their contributions of capital, and is thus not subject to employment taxes but is still subject to ordinary income taxes. An analogy would be an employee of XYZ corporation who is also a shareholder. The wages of the employee are subject to employment taxes, while the dividends from the stock are not. When a person is both the sole owner and employee of the S-corporation, they are required to be paid a “reasonable wage” as an employee based on the value of their labor. They cannot set their salary at zero unless they did not do any work for the business. A few years ago, there were news stories about the IRS cracking down on abuses where people undervalued their salary. Since real estate flipping is a capital-intensive business, and since assets are placed at risk, an S-corporation would seem to be a legitimate structure for real estate flipping. Since much of the profits result from capital assets involved, the portion that is distributed as business income could be substantial for many flip businesses. Every situation is different and matters can get complicated, so anyone considering S-corporation taxation must do their own research or talk to a relevant professional before proceeding.
    Brandon Hall CPA from Raleigh, NC
    Replied about 5 years ago
    Excellent information Matthew!
    Mike Tetzel Specialist from Nashville, TN
    Replied about 5 years ago
    Another great article!
    Russell Brazil Real Estate Agent from Washington, D.C.
    Replied about 5 years ago
    Awesome article Brandon. Doesnt it seem almost every question regarding anything in real estate has an answer depends.
    Cory Binsfield Financial Advisor from Duluth, MN
    Replied about 5 years ago
    Thank you for finally settling the the most misunderstood piece of the tax code. I see too many new flippers out there not factoring in all the gnarly aspects of short term capital gains and self-employment taxes when bragging about their returns.
    Graham Melvin Investor from Bellingham, Washington
    Replied almost 5 years ago
    Really great article, thanks!
    James Masotti Rental Property Investor from Washington Township, NJ
    Replied almost 5 years ago
    Brandon – Given this information how much profit would you recommend that a flipper who classifies their business as a dealer but also has a normal W2 income that places them in a 25% tax bracket set aside for taxes? I know that there are all sorts of business write offs and stuff that can reduce this tax burden but generally speaking my approach to this would be that any “tax savings” throughout the year would just be paid out as a bonus and/or reinvested to the business. Thanks!
    Elizabeth Goff Investor from Napa, California
    Replied over 3 years ago
    Brandon, great article! But you’ve given me pause on my current project and now I’m a bit concerned that I’ll have to treat gains as income. I bought a house with a partner (a real estate agent and friend) 4.5 years ago. We rented it for 4+ years and now we’re undergoing a major renovation before we sell it (decided good time to sell and my partner wanted out)…. We’re adding a porch but no additional space, but cost of reno is fairly significant at $85k on a pre-reno value of probably $425k. Bought it for only $200k so our gains are mostly from appreciation. I have two other rental properties that I’ve had for 7+ years so I do have a ‘track record’ of holding and have not shown that I’m a flipper, not sure if that matters. Do I have to worry about this reno being treated as income? Do we need to rent again before we sell to avoid this? Thanks in advance for your insights…