Tax Strategies for Flipping

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Tax Strategies for Flipping

Jackson TatePro Member
Investor · Brevard, NC · Member since 2017 · 54 posts · 8 votes

I will be selling a flip in a few months and will be very close to the 1 year hold mark on the property.

Other than dumping more money into the property in order to increase the amount of write-offs, does anyone have any tips or strategies they have used to soften the tax hit on their flips?

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Linda WeygantPro Member
Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes
9y

I'm not sure why you're wrapped around the axle about the 1 year mark.  That makes no difference on a flip.  (If you're thinking flipping income is Capital Gains, it's not.  Flipping is Ordinary Income).

Many people find an S-Corp valuable for tax savings for flipping, however you would have needed to set that up at the beginning of this transaction, not at the end, so this is not a strategy that will work for you this time around.

My best advice would be to get with a real estate savvy CPA and explain your experience, your goals and what you've got going on in the rest of your life, because all of that will matter in the advice you get for your future projects.  

For this project - sounds like the time to think about this was a year ago....

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  • Taylor Brugna
    CPA · New York, NY · Member since 2016 · 203 posts · 132 votes
    9y
    Andrew Chambers A house is treated as inventory when flipping, which is completely different from other forms of real estate investing. Real estate is not treated the same in all circumstances, it depends what you are trying to do with it. Buy and hold generally is the most favorable from a tax perspective while flipping is the least.
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  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    9y

    Hi @Andrew Chambers, 

    Unfortunately, no.  It all boils down to the taxpayer's intent.  Did they acquire the property with the intent to rehab and sell (flip) or did they acquire the property with the intent to rehab and hold. 

    Flipping is treated as inventory in a real estate business.  You would not report it on your financial statements as "inventory" in the traditional sense, but probably property held for sale or something like that.  Flipping is always going to be taxed as ordinary income because you are running a real estate business and the property is your inventory/product. 

    Property held for rental, investment or business use is another matter.  It is not treated as inventory because it is not held for sale but rather held as a long-term investment.  Property held for investment would be taxed as capital gains (unless you defer the taxes through a 1031 Exchange, 1033 Exchange, Charitable Trust, etc.) 

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  • Steven Steffel
    VP of Acquisitions and Sales · Columbus, OH · Member since 2016 · 40 posts · 25 votes
    9y
    Scott Hesseltine if you make more than $35,000 in your real estate business it is beneficial to have an S Corp. for your active income i.e. Flipping and a separate LLC for your passive income I.e. Buy and holds aka rentals. The S Corp when structured right saves you a lot of taxes when flipping as well as you can self direct your health insurance as a tax right off also then have your LLC for your buy an holds pay your health savings account as another excellent tax right off while still earning nice active and passive income with an additional risk management buy the shelter of your LLC in case your tenants ( or contractors in your S Corp) have an accident. I hope that helps. Cheers! Steven Steffel
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  • Andrew Chambers
    Decatur, GA · Member since 2017 · 3 posts · 1 vote
    9y

    Thank you for the insight! @Natalie Kolodij @Taylor Brugna and @Bill Exeter. So I have a question. Wouldn't a buy and hold situation only be beneficial in regards to taxes if the person's tax bracket is low (10 to 15 percent taxpayers) because they don't have to pay taxes on assets held longer than a year. Other than that, if their tax bracket is higher they would have to pay additional taxes. I think this goes back to the question of whether or not holding the property for longer than one year is seen as a capital gain or if it is still considered inventory.

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  • Natalie KolodijBusiness Member
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    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    9y

    @Andrew Chambers 

    I'm not sure what you're talking about not paying taxes on assets held over one year? 

    I think what's happening here is you're mixing up tax treatments for several things. 

    Capital gains rate can be 0 if your ordinary income is low enough. However real estate doesn't generate capital gains/losses. 

    If it's buy and hold they will pay tax on the income generated by the rentals. 

    If it's a flip and held for a year they will still pay ordinary income tax and se tax on the flip proceeds. 

    It's still inventory if you do a flip and it takes 3 months- or 3 years. It's basically never capital gains.  (Rareeeee cases- but if you're flipping as a business, always just ordinary income)

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  • Mindy JensenPro Member
    BiggerPockets Money Podcast Host · Longmont, CO · Member since 2014 · 7k+ posts · 10k+ votes
    9y

    @Andrew Chambers , when you purchase a property with the intent on fixing it up and selling it, in the eyes of the IRS it is considered 'inventory' rather than property. You buy low, mark it up and sell for a profit in a quick timeframe. The higher sales price from inventory is income.

    When you purchase property to rent out - regardless of whether or not you improve the property - you are making an investment, and investments are taxed at a different rate. The higher sales price from an investment is a capital gain.

    @Jackson Tate , is the property already under contract? My "investment" method is the live in flip. I live in the property for 2 years and pay 0 capital gains on it. It has to be your primary residence, and since you've owned it for a year without living in it, you'd have to live in it for the next 2 years in order to realize the benefits. Is that an option for you? Depending on the profit, it could be worthwhile to forgo a sale for 2 years.

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  • Account Closed
    Professional · Brooklyn, NY · Member since 2017 · 624 posts · 147 votes
    9y
    Originally posted by @Jackson Tate:

    @Account Closed

    The flip was financed through a conventional with rehab included. The reason I still have it is because there was an unforeseen issue with installing a septic system that required purchasing a contiguous property which I just closed on last week.

    Sounds like some sort of FHA203k financing. Still, the delay, market conditions or the increased unforseen expenses can still dwindle profits. Not sure where you are in real estate or flipping but may have to review this. What amount are we talking about by the way? Value of property, rehab cost, unexpected expense, ARV etc..

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  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    9y
    Originally posted by @Jarrod Williams:

    @Steve Vaughan:  I keep hearing about this.  I think I understand but I want to make sure I have it all ironed out right.  Would you mind helping me with your specifics?

    So your "effective tax rate" has been negative for 14 years. Let me take a stab at what I think this means and where I am getting lost. You have some sort of business entity (LLC, S-corp, whatever) that you do your real estate through. You have a large portfolio of hold properties in that. Those hold properties have expenses, mortgage interest, amortization of points from loans, and depreciation all of which you can use to lower the taxable income from your properties. Allow me to use an example with numbers because it will help show where I am confused.

    You are 3 years in to real estate investing.  You bought 1 property a year for 3 years at $100,000, you put 20% down each time, interest was 5% every time on a 30 year note, you paid 2 points to originate each loan, each property rents for $1000 a month ($1200 gross rent/year/property), 10% loss for maintenance/vacancy, insurance $500 per, property tax $1000/year, no utilities.  Assuming every purchase happened on Jan 1st each year.

    Year 1: NOI - $9300 = (12000*0.9 - 1000 - 500);

    mortgage interest paid = $3315.12

    amortization from points = $160 = (80000*0.02)/10

    depreciation of property = $3636.36 = 100000/27.5

    taxable income = $2188.52 = 9300 - 3315.12 - 160 - 3636.36

    Year 2: NOI - $18600 = (12000*0.9 - 1000 - 500)2

    same order as above - $6588.63, $320, $7272.72

    taxable income = $4418.65

    Year 3: NOI - $27900 = (12000*0.9 - 1000 - 500)3

    same order as above - $9818.81, $480, $10909.08

    taxable income = $6692.11

    So the only way I see to carry a negative tax balance is to spend the taxable income in expenses or capital improvements.  So if you added a bathroom or something to all the properties for 10K a year to push appreciation you would have a loss.  Now your properties are all worth 125K a piece.  You wrap them all into a refinance to realize the appreciation and use that money to buy another property.  Is this how you carry a negative "effective tax rate" and still have cash to grow your business?  What am I missing or have incorrect?  Thanks.

     Hi Jarrod.  Yes, negative 'effective tax rate' for me.  I guess last year I did 'pay' $500, because my wife paid $700 through her w-2 and our refund was only $200.  So ... my tax rate wan't negative for the first time since 2003.

    I haven't had a w-2 since '02.  My wife has had a small one.  With the unearned income tax credits for my 2 boys, we get refunds.  Without kids, I would have paid.

    Early on I bought apt buildings where the land value is literally 3% or less of the PP.  For instance - a $480k apt that values the land at $12k.  A $357k apt that values the land at $6k. My worst one is 9%.  $700k bulding, $60k in land.  My depreciation is huge, that's all.  Houses aren't nearly this good on the depreciation front.  I always factor what the county values the land at when I buy an apt building. It's not by accident.  

    A sweet triplex was for sale and I passed.  CB zoning so the county valued the land at about 40% of PP.  No thanks.  Condos interest me from a depreciation perspective.  No land value at all!

    Lots of straight depreciation coupled with no 'job' - I basically only earn what I save by not paying someone else = low enough MAGI for free school lunches.  But I don't. I have my morals :)  I may show up to pay the lunch bill in my old beater looking like a homeless construction painter plumber, but my cash is accepted.

    Thanks for asking!

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  • Account Closed
    Professional · Brooklyn, NY · Member since 2017 · 624 posts · 147 votes
    9y
    Originally posted by @Andrew Chambers:

    Correct me if I'm wrong, but property is property right? Whether you are buying and holding or flipping a house, at no point is it considered inventory. I know in accounting there is a separation between inventory and property, plant, and equipment. I'm not sure if this is relevant or not. Also, wouldn't it depend on whether the person is buying and selling as an individual or a business.

    Then be corrected! In accounting, the definition of an inventory is a current asset (finished or unfinished) that is acquired for resale and typically converted to cash (sold) within the year. Buying houses (I mean, merchandise) for flips fit that description hence classification of being a real estate dealer and subject to the self employment tax. Based on the deal in question, an additional 15.3% hit on profits that you didn't see coming can be the difference between a flip that makes $en$e and one that doe$n't.

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  • Jarrod Williams
    Investor · Lexington, KY · Member since 2015 · 26 posts · 5 votes
    9y

    @Steve Vaughan:  Thanks for the info.  Never dawned on me to evaluate the look at the percent they attribute to the land even though I knew to do that later for tax prep.  Any idea what goes in to a county evaluation of different land zoning?  Is commercial zoning always going to be valued higher for land compared to residential even if for arguments sake they are right next to each other?

    Still have a little trouble on the taxable income from a macro perspective, anyone else please feel free to chime in as well.  I get deductions, I get expenses, I get depreciation.  What I can't seem to grasp is how an income producing property can both have a depreciation schedule that leads to low to no taxes AND have an income stream significant enough to grow the business?  I'm only a few years in so still working through most of this.

    So 3 buildings (480 - 12 = 468) (357 - 6 = 351) (700 - 60 = 640).  Total assets 1,537,000 depreciated over 27.5 years is $55,890.91 a year.  Lets pretend you filed single and had no kids etc.  Assuming something near the 1% rule the gross income should be around $184,440.  So the expenses, deductions, etc. would have to be almost 130K to not have a tax burden left over?  Am I getting this right?

    You said you only earn what you save by not paying someone else.  Does this mean that instead of hiring a property manager you pay yourself to manage, giving you an income but allowing you to put that down as an expense for the business, and thus lower the businesses taxable profit? Am I understanding that right?

    Thanks for sharing real numbers.  This is helping a lot.

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  • Albert Bui
    Lender · Bellevue WA & Orange County, CA · Member since 2013 · 2k+ posts · 1k+ votes
    9y
    Originally posted by @Jackson Tate:

    I will be selling a flip in a few months and will be very close to the 1 year hold mark on the property.

    Other than dumping more money into the property in order to increase the amount of write-offs, does anyone have any tips or strategies they have used to soften the tax hit on their flips?

     The key differentiating factor from what you've seen above is that you called your property a "flip," when referencing it.

    The "context," and "facts," determine how things are taxed.

    If you had said I had a property I fixed up and your intent was to hold and rent it out, but now after 1 year you're figuring darn the market is so much higher now Im just going to sell it, then it would be taxed as long term capital gains based on applicable rates.

    All you have to do is to change the context/intent/facts and season those parameters prior to your disposition of your property and that would change your tax brackets you're subject to.

    This is the same way for 1031 exchanges too.

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  • Natalie KolodijBusiness Member
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    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    9y

    It also warrants noting that what @Albert Bui is mentioning won't work over and over. 

    If you have a one-off property that fell into your lap, or was a rental gone wrong then you can be subject to capital gains. 

    However if you're doing this year after year and just claiming oh it's intent was rental you're an auditor's dream basically. 

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  • Albert Bui
    Lender · Bellevue WA & Orange County, CA · Member since 2013 · 2k+ posts · 1k+ votes
    9y
    Originally posted by @Natalie Kolodij:

    It also warrants noting that what @Albert Bui is mentioning won't work over and over. 

    If you have a one-off property that fell into your lap, or was a rental gone wrong then you can be subject to capital gains. 

    However if you're doing this year after year and just claiming oh it's intent was rental you're an auditor's dream basically. 

     so all this regular income talk and capital gains talk all hinges upon the fact if the IRS considers him a "trader," for the purposes of taxation right?

    I've seen cases where a person defined as a "trader," status had some assets subject to ordinary income and some assets sold classified as capital gains treatment as well. This person Im referencing also sold 15-18 properties in the year of as well.

    So would you say it depends on the documentation he has or the investor has as well?

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  • Jackson TatePro Member
    OP
    Investor · Brevard, NC · Member since 2017 · 54 posts · 8 votes
    9y

    @Account Closed

    This is my first "flip" and I have done one whole sale and own one rental in addition to my primary residence. 

    I paid 62k for the house, 52k in financed rehab costs, and then add in another what will end up being about 20k out of pocket. Original ARV was 205k but new comps within the last month are moving towards 215k.

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  • Natalie KolodijBusiness Member
    Moderator
    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    9y

    @Albert Bui 

    The IRS looks at the big picture. 

    If someone sold 15 properties in a year because they were retiring and unloading their portfolio 

    VS. Sold 15 properties all which were purchased within the last 12-24 months and never had a renter. 

    The correct way to report this would ultimately be as ordinary income. He purchased it specifically to sell it. He didn't inherit it...or....start advertising as soon as he got it that'd be be a rental available in a few months following renovations...IRS is going to sayhis intent was this to be a business transaction.

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    9y

    Well said @Albert Bui - exactly correct on the nuance of the dreaded four letter word "flipping" and intent.  The awesome thing about America is that accidents can always happen in our favor (short holds etc).  It's when the same accident happens 10 times in one year that it starts looking less and less like a fortunate accident and more like....  

    Unfortunately, there's recent case law where even exchanges with property holds well over a year have been disallowed because it was clear to the service that the intent all along was resale - so no exchange and also no capital gains treatment.  Intent feels squishy and malleable but it's still got to be demonstrable.

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  • Albert Bui
    Lender · Bellevue WA & Orange County, CA · Member since 2013 · 2k+ posts · 1k+ votes
    9y
    Originally posted by @Jackson Tate:

    @Account Closed

    This is my first "flip" and I have done one whole sale and own one rental in addition to my primary residence. 

    I paid 62k for the house, 52k in financed rehab costs, and then add in another what will end up being about 20k out of pocket. Original ARV was 205k but new comps within the last month are moving towards 215k.

     Just my opinion but all of this only matters if your audited and you're brought in to defend your position on why you filed your return the way you did.

    In my limited (i've been audited) experience the IRS audits werent that bad other then the fact it takes 30 minutes to get a hold of someone and you might have to talk to the agent and their manager about 5+ times to get any resolution on things depending on how many rounds of documents are being requested of you. I also keep very good documents on all expenses for each month and each year for each LLC/entity.

    In your situation however, just my opinion and Im not a CPA or anything but you're asking a loaded question in a room full of CPA's and accountants so they will tell you the black and white answer which is right in a "specific," context. However, the intent, the context, and the facts of a property can be documented very creatively.

    At the end of the day perhaps the questions you may want to ask yourself are:

    - do you feel competent enough to defend yourself in front of the IRS with the documents/facts/context/intent you have in your current possession ? (or you can hire one of these CPA's here =P )

    - are you prepared to defend yourself?

    - what are the chances or risk of getting audited on your first buy and rehab property lol? 

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  • JD MartinBusiness Member
    Moderator
    Rock Star Extraordinaire · Northeast, TN · Member since 2015 · 10k+ posts · 16k+ votes
    9y
    Originally posted by @Natalie Kolodij:

    @Albert Bui 

    The IRS looks at the big picture. 

    If someone sold 15 properties in a year because they were retiring and unloading their portfolio 

    VS. Sold 15 properties all which were purchased within the last 12-24 months and never had a renter. 

    The correct way to report this would ultimately be as ordinary income. He purchased it specifically to sell it. He didn't inherit it...or....start advertising as soon as he got it that'd be be a rental available in a few months following renovations...IRS is going to sayhis intent was this to be a business transaction.

     Excellent, main point here being this: you can do anything you want until you get audited. Make sure you have good documentation and basis for anything you claim. 

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  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    9y

    @Jarrod Williams - I believe the county assesses CB zoned parcels at highest and best use, so they assign a really high value to that land no matter what's on it.  Here they do, anyway. All I know is the asking price of that little tri was about $160k and land value assessment was $60k.  

    With my mgt company (s-corp) I do play what-if analysis at EOY.  Some years I charge myself vacancy-fill fees and such or more mgt fees.  Some years I don't.  My mgt co also rents my house for 13.5 days per year.  If I do get into a high tax burden year through asset sales or low expenses, I will establish and fund a defined benefit retirement plan and reduce it's earning for the year. Up to like $30k. But I haven't yet.  I have yet to establish a solo 401k, which I will do, which will allow me to reduce income through qualified plan contributions that let me turn around and buy more RE.

    I always plan my sales incrementally.  Last year, one house. This year 2 houses (l/t buy and holds) - just enough to not cross a threshold.  Figure out the impact of any taxable event PRIOR to executing the event.  

    Here's what I know.  My 'lack of' earned income is practically offset completely by depreciation, expenses, my mgt fees, etc.  It's just enough to keep me at what appears to be poverty for a family of 4.  We even get the retirement saving tax credit for funding IRAs and a 401k.   In the meantime we have a fully funded acquisition account and are paying off our higher rate and higher pita commercial debt.  Have fun out there!

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  • Jackson TatePro Member
    OP
    Investor · Brevard, NC · Member since 2017 · 54 posts · 8 votes
    9y

    @Mindy Jensen

    The property isn't under contract yet as I haven't listed it for sale just yet. Still some things to finish up.

    Unfortunately living in the property for the next 2 years isn't an option though I think I'd like to try that moving forward assuming we can get into a house and area we like. Prices in my market (like yours) of Charleston, SC have skyrocketed and there isn't anything I would deem reasonable within the city that we would want or could afford. It's mainly why we live outside the city to begin with.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    9y

    @Andrew Chambers Wrong.....property bought with the intent to flip Is considered inventory.

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    9y

    Sorry @Andrew Chambers, but property can very well be inventory in the eyes of the IRS.  Developers and builders hold lots as inventory all the time.  This latest market has created a new awareness in the eyes of the service that whole properties can indeed be inventory in the hands of a rehab fixer/flipper.  

    The distinction is if the property is intended primarily to be held it is a real asset and treated as such with eligibility for 1031 and capital gain treatment.  If a property is purchased primarily to resell then it is considered part of inventory creation and the improvements to it are to add value to sell just like any other widget used to make a whatzit.  Ordinary income and no 1031 treatment.

    Again, recent years have seen the rise of the cash flipper where business or individual doesn't matter.  It's possible for each to buy property with the primary intent of resale.  This makes the property inventory with the associated consequences.  Just like it doesn't matter how long the computer stays on the shelf at the Best Buy it was is and always will be inventory because they bought it and the pieces of it to resell.  A property purchased by an investor primarily to resell is inventory until their intent changes to hold.  And then they will be able to demonstrate that in a variety of ways.  

    While it may seem a fine distinction to some, the Service doesn't see it that way.  But they were and are unprepared for the sheer volume of transactions happening this way.

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  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    9y

    Hi @Albert Bui, 

    You are absolutely correct.  The IRS typically looks at the circumstances and fact pattern of each individual property and not the entire portfolio.  There are numerous ways that you can document your intent on a property-by-property basis.   Again, it all boils down to what you can demonstrate to the IRS (or state taxing authority) should you be audited. 

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  • Account Closed
    Professional · Brooklyn, NY · Member since 2017 · 624 posts · 147 votes
    9y
    Originally posted by @Albert Bui:
    Originally posted by @Jackson Tate:

    @Account Closed

    ...all of this only matters if your audited and you're brought in to defend your position....However, the intent, the context, and the facts of a property can be documented very creatively....what are the chances or risk of getting audited on your first buy and rehab property lol? 

    So you just went from negligence to willful attempts to deliberately evade taxes -- have you looked at the definition of tax fraud recently? Creative documentation? Rolling a dice on if you are going to get audited? This is really the type of advice that you are dishing out?

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  • Account Closed
    Professional · Brooklyn, NY · Member since 2017 · 624 posts · 147 votes
    9y
    Originally posted by @JD Martin:
    Originally posted by @Natalie Kolodij:

    @Albert Bui

     Excellent, main point here being this: you can do anything you want until you get audited. Make sure you have good documentation and basis for anything you claim. 

    No.... there is something called the IRS code. It dictates what you do on matters pertaining to tax. Talks about 'doing anything you want until you get audited' is bad advise and irresponsible.

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