capital gains tax on my short term flip?

17 Replies

Good Evening. I live in San Diego CA and i am about to sell my third flip this year.

My First two flips the FTB took a larg percentage from Escrow for cap gains. In reading thorugh some of the other posts its seems as if i should NOT be paying cap gains tax at all?

If this is true can some please enlighten me?

Any San Diegans have a local CPA i can speak with.

No capital gains tax on income from flipping.  Its worse than that.  Its ordinary income and subject to income tax at your marginal rate.  Plus its subject to self employment tax.  Because you're self employed you have to pay both halves, unless you hit the limit on social security.  No limit on the medicare part.

Jon Holdman is right. You can end up paying half your profit in tax if you are successful enough to be in a high tax bracket. Buy and hold investing is far more tax efficient.

Thanks for the response.

Clint, this is a california issue the FTB has a 3.3% witholding out of the gross resale, your answear will be found on the PCOR, read who is excempt from witholing and how you enter into escrow on the resale. You will better of if you also buy under that same name, read the excemptions and choose one, exp: Partnership.Consult with a good CPA. That will be your solution. Good Luck

You can end up paying half your profit in tax if you are successful enough to be in a high tax bracket.

Yep.  If you're single in CA and your AGI is $100K you'll be taxed on the profits from the flip as:

Federal: 28%

State: 9.3%

Social Security: 6.2% + 6.2% (max income of $117)

Medicare: 1.45% + 1.45%

Total: 52.6%

So there is no benifit with running it through an S corp?

My CPA does not seem to be knowedgeable enough with this stuff. Can someone recomend a good CPA in CA?

I am new to this but I work for a tax attorney and some of our clients use a 1031 exchange so wouldn't that be an option to use? Maybe worth taking a look at that, our office works with a CPA and he may be able to help you.

Good Luck!

Nathalie

@Nathalie Hirsch no.  1031 applies to investments only.  While we talk about fix and flipping and wholesaling as forms of real estate investment, the IRS does not see them as such.  They are active businesses and the income is ordinary income.  Houses you're fix and flipping are inventory, not investments.  So 1031 is not available for fix and flips.  If you know fix and flippers or wholesalers who are doing 1031's they are committing tax evasion.  As with many crimes you might get away with it for a while.  But if you get caught there will be consequences.  1031's come into play when you sell a rental and buy another one.

@Clint Worland an s-corp may have an advantage with fix and flips and the SET (self employment tax). The idea is that you can do the flips inside the s-corp (or LLC taxed as an s-corp) and pay out part of the profit to you as distributions. Those distributions are still taxable but are not subject to SET. However, you would still have to pay yourself a "reasonable salary" from the s-corp for the work you do. So, if you made $100K doing fix and flips you wouldn't be able to pay yourself $1 and pay the remaining $99,999 as a distribution. The IRS would say $1 is not a reasonable salary. Whatever number you come up with will need some basis.

Further, the social security part of that tax is limited to $117,000 of income (in 2014).  If you have a regular job and make more than $117K, you're not going to be paying the social security part on the rehabbing income anyway.  That's the bulk of that SET, 12.4%.  That leaves only the 2.9% medicare tax that you would be able to avoid.

So, trying to do this in an s-corp may or may not be worthwhile, depending on several factors.

@Jon Holdman

Thank you for the clarification, I didn't realize there is such a distinction with the IRS! I still have lots to learn and yes, the clients in our office use it for primary residences and investments(rentals).

@Nathalie Hirsch   a 1031 exchange cannot be used for a primary residence, either.  Its strictly for investments.  Not just real estate, but it has to be an investment and it has to be a "like kind" investment.   You could, for example, sell a heard of cattle and buy other cattle or horses and do a 1031.  But you couldn't sell cattle and 1031 the proceeds into real estate or vice versa.

@Nathalie Hirsch

Hi Nathalie, flips do not qualify for 1031 Exchange treatment. Flips are acquired with the intent to hold for sale and are not held for investment as required for tax-deferred exchange treatment under Section 1031.

@Clint Worland

Hi Clint, I just PM'd you a referral to a CPA firm in San Diego that is very knowledgeable on real estate.

Are you talking about the FTB 3.33 withholding on the 593-C?  It's not a tax.  It's a withholding.  You report your profits on a short term flip as Schedule C business income.  The withholding is a credit that will be applied to to any tax you owe. If you owe less than what was withheld, you will get a refund from the state.

@Jon Holdman

I will clarify what I have seen done here in San Diego, particularly in affluent areas like La Jolla. A couple bought their home back in the 90's for x amount of dollars, well it is well over that price x today, so they have been advised that they could turn their residence into a vacation home(and conduct it as an investment) and rent it out for a set amount of time( of which I do not know) after that period has passed they can then use a 1031 exchange because that residence is now used as an "investment property"

Obviously, I am no attorney or expert of any kind but I'd assume it was legal to do this as it is quite common here(shady, definitely) but it is what I have seen and am not saying I agree with it or presume to know the fine tuned details of what else transpires.

@Nathalie Hirsch  There are certain 'safe harbors' and guidance from the IRS in connection with vacation home rentals.

The IRS will not challenge whether a dwelling unit qualifies as §1031 exchange property held for productive use in a trade or business or for investment if: (1) the relinquished property is owned by the taxpayer for at least 24 months immediately prior to the exchange and a replacement property is owned for at least 24 months immediately after the exchange (the “qualifying use period”) and (2) within each of the two 12 month periods constituting the qualifying use period, the taxpayer must:

(a) Rent the property to another person or persons at a fair rental for 14 or more days; and

(b) The taxpayer’s personal use of the dwelling unit cannot exceed the greater of 14 days or 10 percent of the number of days during the 12 month period the dwelling unit is rented at a fair rental.

Originally posted by @Clint Worland :

So there is no benifit with running it through an S corp?

If you are an LLC or corporation, you can avoid having the tax withheld upon the sale. A competent escrow person should know what to do. I think it's just checking the right box on form 593-C if I remember.

Originally posted by @Nathalie Hirsch :
@Jon Holdman

I will clarify what I have seen done here in San Diego, particularly in affluent areas like La Jolla. A couple bought their home back in the 90's for x amount of dollars, well it is well over that price x today, so they have been advised that they could turn their residence into a vacation home(and conduct it as an investment) and rent it out for a set amount of time( of which I do not know) after that period has passed they can then use a 1031 exchange because that residence is now used as an "investment property"

Obviously, I am no attorney or expert of any kind but I'd assume it was legal to do this as it is quite common here(shady, definitely) but it is what I have seen and am not saying I agree with it or presume to know the fine tuned details of what else transpires.

Hi Nathalie,

The strategy that you outlined above is not "shady." The IRS actually issued Revenue Procedure 2005-14, which clearly allows a taxpayer to convert their primary residence into rental or investment property and then take advantage of both the 121 Exclusion ($500,000 tax free exclusion) and the 1031 Exchange upon the sale.

The taxpayer has to make sure that they sell (and close) on the property no later than the end of the third year after they move out of the property and convert into rental or investment use in order to qualify for both the 121 Exclusion and the 1031 Exchange. If they miss the three year window, then the property would only qualify for 1031 Exchange treatment and they would lose the 121 Exclusion.

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