During the past few months I have seen quite a few blogs, posts, and comments about how taxes are assessed on fix and flip properties. There seems to be a lot of confusion and conflicting information so I wanted to use my blog this week to focus on some of the basics of how fix and flip properties are treated for tax purposes.
To start off, it is important to note what exactly a fix and flip property is. If you are an investor who is in the business of purchasing properties, rehabbing them and then selling it quickly for a profit, then this may fall under the fix and flip definition. With a flipper, the intent of the investor is to buy, improve, and quickly sell a property or properties. In the eyes of the IRS, this is treated as an active business and has the same tax treatment as if you were in the business of buying and selling cars for a living.
The downside of flipping for tax purposes is that higher taxes are frequently associated with flipping income as compared to rental income. Here are a few of the major downsides tax-wise of flipping:
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1. No Capital Gains Treatment
If a flipping transaction is considered active income, there is no long term capital gains tax treatment, even if you have owned the property longer than a year from the purchase date to the sale date.
2. No 1031 Exchange
When we own rentals, one of the greatest tax deferral techniques that we often use is the 1031 exchange. The 1031 exchange allows us to sell a property for a gain and defer the associated taxes, provided that we roll the funds into another investment property. However, since flipping is not considered an investment activity to begin with, there is no 1031 exchange that can be used with respect to flipping activities, even if all the proceeds were re-invested back into another flip.
3. Payroll or Self-Employment Taxes
If a flipping transaction is treated as an active income, it means that the person actively involved in the deal may also be subject to payroll or self-employment taxes. This is accrued by flippers the same way it is accrued by those who work a W-2 for a living or maybe a realtor who makes commissions income via a 1099. Fortunately, with the correct legal entity structures, a significant portion of the payroll/self-employment tax may be avoided.
What Can Be Done?
As you can see, there are quite a few tax pitfalls when a transaction is considered a flip. From a strategic planning perspective, it is important to clearly understand what defines a flip transaction and what can be done to avoid this designation.
Luckily for investors, the IRS does not have a strict set of guidelines to define what constitutes a flip transaction. For example, there is no court case that says “if you flip 3 or more properties then you are deemed to be a flipper and if you flip less than 3 properties you are ok”. In fact, the Tax Courts make their determination on a property by property basis.
This means that one taxpayer can be deemed to be a flipper with respect to one property and not a flipper on other properties that he sells during the year. In fact, one taxpayer sold several properties in a particular year and of the handful that he sold, only 2 of them were deemed to be “flips” and the rest were allowed as investment properties eligible for the capital gains treatment.
If you are wondering how this could happen, the answer is simply that the determination of each transaction is based on its own set of facts and circumstances. One property may have a very different set of facts and circumstances from the next and in these cases, even if the investor is the same person, those two transactions can have very different tax treatments.
One of the most powerful facts that can work in your favor if you are looking to avoid the flipper designation is the word intent. What your intentions are with respect to a transaction can have a significant impact in terms of how much you pay in taxes.
For example, I had a client who purchased a property, rehabbed it, and sold it all within a 4 month period. On the face of it, this looks to be a flip transaction right? Well, not so fast. For this particular taxpayer, his intent going into the property was actually to rehab it and hold it out as a long term rental.
In fact, even before the property was fully rehabbed, he already listed it for rent and people started to come by to view the property before it was ready. As luck would have it, one of the people who came to preview the property made an offer to purchase the property. Even though it was the taxpayer’s intent to keep it as a long term rental, this unanticipated offer to purchase it was too good to pass up and he decided to sell it right after the rehab was complete.
In this scenario, even though it was purchased, rehabbed, and sold in just a few short months, his intent with respect to this transaction was that of an investment and not of a flip and as such, he was able to get all the preferential tax treatments as an investment transaction. Since he ultimately decided to reinvest the proceeds back into another long term rental, he was able to use 1031 exchange to roll all the profit into the replacement rental property he later purchased and therefore paid zero tax the year this first unit was sold.
As with most things in taxes, the law can often be complex. Sometimes the complexities work to your advantage and other times it takes a little more digging into.
Do you have any stories where you had a big win with taxes?
Be sure to leave your comments below!