Will My Flips Qualify for Long-Term Capital Gains or Will I Need to Pay Self-Employment Tax?
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:
- The nature and purpose of the acquisition of the property and the duration of the ownership;
- The extent and nature of the taxpayer’s efforts to sell the property;
- The number, extent, continuity and substantiality of the sales;
- The extent of subdividing, developing and improving the property that was done to increase sales;
- The use of a business office and advertising for the sale of the property;
- The character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and
- 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:
- Was the taxpayer engaged in a trade or business, and if so, what was that trade or business?
- Was the taxpayer holding property primarily for sale in that business?
- 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.
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:
- The frequency and substantiality of sales,
- Development activities,
- Solicitation and advertising efforts, and
- 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.
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!