How to avoid self employment tax when flipping properties?

Question

Hi all,

A friend of mine and I are planing to partner up and fix and flip properties. We plan to put down payment together, get a hard money loan, rehab and then sell properties. I am an experienced buy-and-hold investor and have been doing this for a few years. But this would be my first time fixing-flipping properties. I have a full time W2 income (not related to real estate) and do my investing part-time.

I have been reading online, and there seems to be a chance that IRS can label us as a "dealer" if we flip a few properties in a year, and then we can be subject to the 15% self employment tax. We would like to avoid that from happening. Hence I would like to ask experienced folks on the board who have been flipping homes - what can we do to avoid being given the "dealer" status by the IRS? Do we need to use entities (like LLCs, C or S-corps, etc) to overcome  this?

Any information on this would be greatly appreciated. Thanks everyone.

Tyler Smiarowski · Answer

If you have a day job a lot of CPA's I know (myself included) would not consider someone who has a day job and flips homes on the side as "self employment income". Many CPA's treat this no differently than stock sales.  Basically the "house flip" gets put on Schedule D of your tax return and is subject to federal and state tax, but no self employment tax.  If your only flipping houses and no day job...then it would be viewed as self employment income.

So you would either put that on your Schedule C of your tax return where you are subject to the full 15.3% self employment tax based on your net income on your Schedule C or you can set up an S-Corp...pay yourself a "reasonable salary" and then take the rest as a dividend. Only your salary in the S-Corp would be subject to self employment tax.

I currently work full time as a CPA, the 1 house flip I will complete this year will go on my Schedule D of my 2014 tax return.

Jon Holdman · Answer

All income from flipping properties is ordinary income and subject to SET.  Doesn't matter if its one a year or 100.

One way to reduce the SET is to use an s-corp for doing the flips.  The S-corp must pay you a reasonable salary, which is subject to SET.  The income above that can be distributed from the s-corp to the owners (you).  No SET on that part.  And, no, $1 is not a reasonable salary.

Also keep in mind that if you have a day job this may be less of an issue.  The limit on income for social security (the bulk of SET) is about $100K.  If you're making that much or more from another job, you won't be paying the social security tax on the flipping income.

Eric P. · Answer

I am surprised no one mentioned that the $118k limit on self-employment tax only applies to the Medicare portion of the self-employment tax which is only a piddly 2.9%. You will pay the other 12.4% of self-employment tax on all income, even income well over $118k.

I am surprised that I'm on a thread of accountants and as a non-accountant, I am the one mentioning this. Am I wrong about it?

Greg F. · Answer

Hi Andy,

My brother/partner and I just stood up an S-Corp for the transactional income, which is fix and flips, wholesaling, and quick cash. We do have W2´s outside of investing. Our team of advisors said it is best to use an S-Corp for this kind of income. You can stand up a LLC and select S-Corp taxes. The reason why we stood up the S-Corp now is because we are both going full time in REI. This might be the difference on what you are looking for and what our advisors suggested we do. Although not everyone has the same opinion on everything, I would suggest finding a REI friendly law firm and get there thoughts before moving forward.

vision without action is a dream, action without vision is a nightmare!!

Michael Lee · Answer

Hello and welcom to this website!  You might need to hire a tax consultant to tell you the best way to handle what you are trying to do.  I have only bought one investment property myself and i do not know of any other way that heard from the people that held their property for over one year to claim any income as long term.  As long as you are making the invest in a property that will turn on some income that will exceed you self-employment tax.

You could get the same tax consultant that can do your tax return.  Make sure they have enough experience to help you.    I am a little surprised that you found the problem about self employment tax and brought that up.  The way others have talked about investments but have  never brought that up and I have been on this site daily for right over a year while recovering from a medical problem.

Just budget as an expense that the property will more than pay for that  or do not do any work on the property you buy except finding it and doing the paperwork and get "paid" by the profit.  More than likely the depreciation will make you not owe any tax money.  One way you can make a house a long term investment and rent it out until you can sell it.

You might have to do more work when selling versus renting.  Just go by the demand for the subject property to determine your value in that location.  Try to locate your prospective properties in a nice neiberhoodc where yours is located..  A good looking neighberhood will help you sell it.

Pay yourself as little as you can get until you sell the subject property.  You might get a cheaper tax when you can claim less expense for yourself.  I am sure that it is just a paperwork thing.  Do not count every penny and you will be better off.  You can look for properties that don't need as much work and contract most of the work gone by a Contracors you hire.  Just be more focused on income productive things.

The tax consultant will help you to do advantage property renovations and save you money only legally.  They will be worth every penny you have to spend and get you that peace of mind.  Good luck to you!

John Thedford · Answer

Flipping properties does not qualify them for long or short term capitol gains. They are inventory. The only way you could receive long or short term capitol gains treatment would be if you rented them for the required times as stipulated by the IRS. If you rehabbed one and it sits on the market for months that won't work either. They would have to be held as rental properties, marketed as such, etc. If you do choose to go this route, rental income would be documentation that they were held as investments rather than regular inventory. Ask one of the tax experts on BP. I do know I have been lending on properties (vacant land) that are being held for a year and one day so they qualify for the capitol gains exemption. What would make these "investments" rather than inventory I am not clear on.

Jonathan Klemm · Answer

@Andy K - Did you ever happen to get your 2nd question answered about short term capital gains?

Tyler Smiarowski · Answer

Also just because your income is considered "ordinary income" does not mean it is subject to self employment tax. It just means it will be taxed at whatever your marginal tax rate is.

Andy K · Answer

Thanks Jon for your reply. So anyone with a day job outside of real estate with a W2 income greater than or equal to 100K or so will not be subject to SET from the flipping profit. Will the profit from flipping be then called short term capital gain tax?

If one is not going to be hit with SET from flipping on account of having a day job, is there any real benefit to using an entity like S-corp or LLC for the flips? Or it should be okay flipping the property as an individual? Thanks.

How to avoid self employment tax when flipping properties?

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