Tax Protection for Flipping Income

33 Replies

We're starting our flipping business this year in order to fund our buy and hold strategy. And I understand that income from rehabs/flips is taxed at the highest level. However, we intend to use all profits for the purchasing of our long-term holds. I'd like to keep as much as we can using a corporation. Is this following feasible?

Set up a corporation, with minor payroll of the owners, but keep a majority of the flipping profits with the corp. and have the corp. then purchase the buy and holds. 

Will that reduce our tax liability? We have every intention of getting direct legal counsel, but wanted to vet the question on the forum first.

Thanks for any input!

Originally posted by @KJ D'Costa :

We're starting our flipping business this year in order to fund our buy and hold strategy. And I understand that income from rehabs/flips is taxed at the highest level. However, we intend to use all profits for the purchasing of our long-term holds. I'd like to keep as much as we can using a corporation. Is this following feasible?

Set up a corporation, with minor payroll of the owners, but keep a majority of the flipping profits with the corp. and have the corp. then purchase the buy and holds. 

Will that reduce our tax liability? We have every intention of getting direct legal counsel, but wanted to vet the question on the forum first.

Thanks for any input!

 It may add too much complexity, but isn't a 1031 exchange an option with a flip?

No a 1031 exchange is absolutely, positively NOT an option for a flip.

Originally posted by @KJ D'Costa :

We're starting our flipping business this year in order to fund our buy and hold strategy. And I understand that income from rehabs/flips is taxed at the highest level. However, we intend to use all profits for the purchasing of our long-term holds. I'd like to keep as much as we can using a corporation. Is this following feasible?

Set up a corporation, with minor payroll of the owners, but keep a majority of the flipping profits with the corp. and have the corp. then purchase the buy and holds. 

Will that reduce our tax liability? We have every intention of getting direct legal counsel, but wanted to vet the question on the forum first.

Thanks for any input!

First Flaw: You NEVER EVER want to hold long term real estate in a corporation. Distribute the income out and purchase it personally or in a single member LLC (or in your case a husband-wife multi-member in a community property state it still is treated as disregarded).

Consider also utilizing a C-corp if you are currently in a tax bracket that would make it worthwhile.

You're only hope is a cost segregation study and a ton of depreciation to offset some of the gains.  You will still have a tax liability.

A 1031 is not an option with flips.

Medium hta logoSteven Hamilton II EA, Hamilton Tax and Accounting | [email protected] | (224) 381‑2660 | http://www.HamiltonTax.Net

Properties bought for rehab/flipping are held for sale and not held for rental or investment purposes and therefore to not qualify for 1031 Exchange treatment.  You must have the intent to hold for rental or investment purposes.  Properties bought for rehab/flipping are really real estate inventory in your real estate business. 

Medium exeter 1031 clr cntr bBill Exeter, Exeter 1031 Exchange Services, LLC | [email protected] | (619) 239‑3091 | http://www.Exeter1031.com

What @Steven Hamilton II  said.  You never, NEVER want to hold investment properties in a corporate entity.  The "flip" income MAY benefit from a corporate tax structure, but that would depend on the amount of net profit earned this year.  It's good that you're consulting your tax pro.  He (or she) is in the best position to give you advice appropriate for YOUR tax situation.  One size does not fit all ;)

Thanks for all the replies.

I wasn't considering a 1031 because it doesn't fit our strategy. 

@Bill Walston   and @Steven Hamilton II I hear you loud and clear, but can you detail what is so detrimental about holding investment property in a C Corp? That means that only business structure that's smartwould either be an LLC or a land trust for each separate property?

Anyway, I was hoping that there was some time of business structure that would take into account that flip profits would be turned around and used to purchase assets and not be spent as personal income. Hurts so bad to think that 40% is going to the tax man...sigh.

I have few consultations lined up next with tax attorneys. I'll post the results.

What you do with income is not relevant to how its taxed.  Income from flipping properties is EXACTLY the same as income from a shoe store.  You get to deduct all your expenses, both the inputs (i.e., cost of good sold - the shoes you buy wholesale or the properties, labor and materials) and overhead (insurance, office space, etc.) but the net profit is taxable as ordinary income.

You may be able to shelter some of the income by using an s-corp. Because that's ordinary income, you must pay SET (self employment tax - social security plus medicare) on it. With a W2 job, the employee pays half of that and the employer pays the other half. With any self employment income, whether flipping houses or that shoe store, you pay both halves. If you do the flips in an S-corp or an LLC taxed as an s-corp, and you have enough income, you may be able to distribute part of it as salary (subject to SET) and part as distributions (not subject to SET). But the salary must be "reasonable", which is to say what someone might be paid to do a similar job.

There's no trick here.  Fix and flipping is a job, not investment.  Its taxed exactly the same as a W2 job.  Doesn't matter what you're going to do with the money.

Jon Holdman, Flying Phoenix LLC

@KJ D'Costa 

You need to realize the two are separate things and you DO NOT want to have flips and rentals in the same entity.  It becomes hard to prove to the IRS what is inventory and what isn't.

If there is more than one shareholder of an LLC it is taxed as a partnership UNLESS you are in a community property state.

You need to understand that an LLC DOES NOT EXIST as far as the IRS is concerned: http://www.biggerpockets.com/forums/12/topics/76052-simple-taxation-questions

You can flip in a C-corp or s-corp and then distribute the income or even loan from there.

Personal Holding Company Tax (PHC Tax) is a 20% tax on a corporation that holds passive based income that GROSSES more than 60% of the income.

C-corps have NO CAPITAL GAIN RATES.

Here is a thread on Real Estate in a C-corp and trying to get it out: http://www.biggerpockets.com/forums/51/topics/1057...

Medium hta logoSteven Hamilton II EA, Hamilton Tax and Accounting | [email protected] | (224) 381‑2660 | http://www.HamiltonTax.Net

If your business plan has a goal of flipping SOME properties in order to raise capital for your long term investments, then the flips are not considered "dealer" properties and you can take advantage of tax benefits designed for investors.  MAKE SURE your accountant does not report the income on Schedule C.  If your accountant is not on board with this, get a new accountant!  You can't flip a lot of properties and rely on a business plan to "hide" your from the wrath of the IRS. But, if you strategy is truly to do a few flips to raise capital, you should be okay.

Denise Evans JD, Butler Evans Education | [email protected] | 205‑646‑0453 | http://www.ButlerEvansEducation.com

If you have access to Federal Court reporters, you might want to read the case of Byram v. Commissioner, 705 F.2d 1418 (5th Cir. 1983) for a decision that 22 flips in 3 years were, nevertheless, investment properties.

Denise Evans JD, Butler Evans Education | [email protected] | 205‑646‑0453 | http://www.ButlerEvansEducation.com

Originally posted by @Denise Evans :

If you have access to Federal Court reporters, you might want to read the case of Byram v. Commissioner, 705 F.2d 1418 (5th Cir. 1983) for a decision that 22 flips in 3 years were, nevertheless, investment properties.

Actually @Denise Evans, that wasn't the decision of Byram v. Commissioner at all.  The case DID mention that Byram sold 22 properties in three years, but only SEVEN properties were at issue in the case, not twenty-two.  And I certainly don't find the facts of Byram applicable to typical wholesalers and rehabbers.

First,  the typical wholesaler or rehabber purchases property with the intent to assign for a quick profit or to "fix and flip" for a profit.  That wasn't the case of Byram who held six of the seven  properties from periods ranging from six to nine months, the seventh was held for over two years. That time period, in and of itself, would imply that the property was bought to hold for investment purposes.

Second, not only did Byram not list the properties with brokers, he didn't even advertise the properties for sale. All of the transactions were initiated by the purchaser or someone acting for the purchaser. Again, this is totally atypical of wholesalers and rehabbers and could be interpreted as intent to hold the property for investment. 

Attempting to use Byram to support a theory that the typical fix and flip can be reported as an investment and not as business income is quite a stretch.  Just sayin' :)

Originally posted by @Percy N. :

Is SDIRA an option?

 Percy, do you mean have the SDIRA purchase the property?  I think the SDIRA is not an option in the case of a flip or rehab due to UBIT issues.

Originally posted by @Percy N. :

@Bill Walston, I was assuming it would be a cash purchase and rehab.

However, if there is UBIT, isn't that just a matter of proper tax filing?

 True enough Percy.  It's a matter of filing a Form 990-T and paying income taxes at the corporate rate. And estimated taxes should be paid during the year if the tax is expected to exceed $500.  So the income wouldn't be shielded from income tax, and since that was the question posed by the OP I answered that an SDIRA wouldn't be an option.  (NOTE:  It WOULD be a source of the cash for the purchase.)  

Originally posted by @Steven Hamilton II :

@KJ D'Costa 

You need to realize the two are separate things and you DO NOT want to have flips and rentals in the same entity.  It becomes hard to prove to the IRS what is inventory and what isn't.

If there is more than one shareholder of an LLC it is taxed as a partnership UNLESS you are in a community property state.

You need to understand that an LLC DOES NOT EXIST as far as the IRS is concerned: http://www.biggerpockets.com/forums/12/topics/76052-simple-taxation-questions

You can flip in a C-corp or s-corp and then distribute the income or even loan from there.

Personal Holding Company Tax (PHC Tax) is a 20% tax on a corporation that holds passive based income that GROSSES more than 60% of the income.

C-corps have NO CAPITAL GAIN RATES.

Here is a thread on Real Estate in a C-corp and trying to get it out: http://www.biggerpockets.com/forums/51/topics/1057...

Are there any reasons why it is a bad idea to have your s-corp or LLC with s-corp election that you use for flips to be the same company that does retail license and bonded general contracting for the public?

@Bill Walston , I was not saying that was the decision of Byram, I said to take a look at it.  It is the beginning point of research on this topic.  I am comfortable with the advice I gave, and have no need to spend hours on the legal research finding the support.  If someone else wants to do that, I gave them a starting place.  No, the decision is not relevant to the typical wholesaler. It is relevant to the original question, which related to a desire to engage in some flips to generate capital for long term capital gains. That is defensible as investment income, not ordinary income.  And, while you are correct that only 7 flips were at issue, the  history of 22 sales was a factor in the analysis.

Denise Evans JD, Butler Evans Education | [email protected] | 205‑646‑0453 | http://www.ButlerEvansEducation.com

@Denise Evans , thanks for the clarification.  I inferred that you were suggesting Byram was typical to wholesale deals.  That is the problem, sometimes, of forum communication - context can be lost.  Sorry about that :)

@Bill Walston , my bad for not being clear.  I see I posted at 6:21 in the evening. Note to self:  "Remember, you are a morning person who usually rises at 5am, and not at the top of your form in the evenings. DO NOT POST after 3pm!"  That probably explains why I started looking for legal precedent on this issue and then gave up and was satisfied with a nudge in the right direction!  I'll see if I can find some more definite guidelines to share with everyone. It's often not the IRS we have to convince, but our own accountants. :)

Denise Evans JD, Butler Evans Education | [email protected] | 205‑646‑0453 | http://www.ButlerEvansEducation.com

Originally posted by @Denise Evans :

@Bill Walston, ... It's often not the IRS we have to convince, but our own accountants. :)

AGREED!!! LOL

@Denise Evans that's an excellent case and one that I try to refer to as often as I can, though @Bill Walston is right when he stated that it's a bit odd to support the typical flip with that case.

If a client of mine has flipped multiple properties in one year, I'd be very hesitant to report those on Schedule E. The facts and circumstances would have to line up perfectly in order to get my Schedule C buy in. To argue "if your accountant is not on board with this, get a new accountant!" is also a bit off in my opinion as it suggests taxpayers should only hire extremely aggressive (borderline unethical) accountants. Instead, the statement should have said "if you accountant is not on board with this, ask them why." You hire an accountant to provide you with expert advice, not to throw you into tax lawsuits.

That said, if the facts and circumstances do align, I'll report on Schedule E all day. I need to be able to support the tax position I'm taking, but I'm not the one who creates the facts and circumstances.

Regardless, this has been a great discussion!

The Case

Byram had a large real estate (rental) operation in place. Because of this, he could buy properties and demonstrate the intent to hold for investment purposes and not "held for sale in the ordinary course of the taxpayer's business."

Byram's real estate business allowed him to sell the properties with "no personal effort to initiate the sales; buyers came to him. He did not advertise, he did not have a sales office, nor did he enlist the aid of brokers." Those two sentences alone will bar the typical mom and pop flipper from claiming cap gains on the profits.

Intent is evaluated at the property level, though the entire entity can be used to support intent as well. The Winthrop factors are used to evaluate intent. The most important are frequency and substantiality of sales. Improvements to the property, solicitation and advertising efforts, and brokerage activities are also especially relevant considerations.

The IRS argued that the sales were frequent and substantial to his business. The court ruled otherwise. I feel that the court likely viewed the average hold period of all his properties and compared the hold period of those in question to that hold period to determine "frequency" and took Byram's entire business into scope when considering "substantiality."

Medium logo blackBrandon Hall CPA, The Real Estate CPA | http://www.therealestatecpa.com | Podcast Guest on Show #196

@Brandon Hall , excellent advice.  I'm afraid I've had very bad experiences with accountants who refused to have discussions with me, but basically took the parents' line, "Because I said so, that's why."  It colors my judgment sometimes, and I should not have been so flippant with my comments. Thank you for taking the time to add your insights and comments. If my accountant or lawyer can give me a reasoned explanation to why they want to do or not do something, then that's terrific. If I disagree, then it's a matter of "Who is willing to take the risk of a bad decision in an iffy area?"  If I want to take the risk, but the accountant is unwilling to sign off on the tax return, then we should part ways.  On the other hand, I am appalled at the number of gurus who advise bogusing up a business plan, and as long as the paper in the file is okay, the taxpayer is okay. As if the IRS is populated by gullible idiots. If you are flipping as an incidental activity to support your investments, then I think you should get investment tax treatment.  If you are a flipper, BE A FLIPPER.  There are many tax advantages available to flippers that are not available to investors.  Many reported decisions on this topic are people who WANTED to be characterized as selling properties in the ordinary course of business, rather than mere investors.  Perhaps you could start a thread on tax advantages available to flippers but not investors. I'm sure there would be a lot of interest in that.

Denise Evans JD, Butler Evans Education | [email protected] | 205‑646‑0453 | http://www.ButlerEvansEducation.com

@Denise Evans I'll consider writing such an article for a future blog post, great idea! And one thing everyone should understand is that accountants are generally introverts who wish to crunch numbers rather than explain their positions to clients. But not all of us are like that, and I think having an accountant who will explain their reasoning to you is critical for all investors AND business owners. You want your business acumen to grow, and a good accountant will help with that :)

So yes, if your accountant isn't explaining things, time for a new one!

Medium logo blackBrandon Hall CPA, The Real Estate CPA | http://www.therealestatecpa.com | Podcast Guest on Show #196