Prior to the recent economic downturn, flipping real estate was popular. With mortgage interest rates low and home prices at historical lows, flipping appears to be on the rise again. House flipping is, essentially, purchasing a house or property, improving it, and then selling it (presumably for a profit) in a short time period. The key is to find a suitable fixer-upper that is priced under market for its location, fix it up, and resell it for more than it cost to buy, hold, fix up and resell it.
If you are contemplating trying your hand at flipping, keep in mind that you will have a silent partner, Uncle Sam. He will be waiting to take his share of any profits in taxes. (And probably, Sam’s cousin in your state capitol will also expect a share.) Taxes play a significant role in the overall transaction. Tax treatment can be quite different, depending upon whether you are a dealer, an investor or a homeowner. The following is the tax treatment for each in years after 2012.
Dealer in Real Estate
Gains received by a non-corporate taxpayer from business operations as a real estate dealer are taxed as ordinary income (10% to 39.6% ). In addition, individual sole proprietors are subject to self-employment tax of 15.3% of their net profit (the equivalent of the FICA taxes for a self-employed person). Higher-income sole proprietors are also subject to an additional 0.9% Medicare surtax on their earnings. Thus, a dealer generally will pay significantly more tax on the profit than an investor. On the other hand, if the flip results in a loss, the dealer should be able to deduct the entire loss in the year of sale, which would generally reduce his income tax at the same rates.
Investor
Gains as an investor are subject to capital gains rates (maximum of 20%), if the property is held for more than a year (long term). If held short term, ordinary income rates (10% to 39.6%) will apply. An investor is not subject to the self-employment tax, but could be subject to the 3.8% surtax on net investment income for higher income taxpayers. A downside for the investor who has a loss from the transaction is that after combining all long- and short-term capital gains and losses for the year, his deductible loss is limited to $3,000, with carryover to the next year of any excess capital loss. The rules get a bit more complicated, if the investor rents the property while trying to sell it—scenario is beyond the scope of this article.
Homeowner
If the individual occupies the property as his primary residence while it is being renovated, he would be treated as an investor with three major differences: (1) if he owns and occupies the property for two years and has not used a homeowner gain exclusion in the two years prior to closing the sale, he can exclude gains of up to $250,000 ($500,000 for a married couple), (2) if the transaction results in a loss, he will not be able to deduct the loss or even use it to offset gains from other sales, and (3) some improvement costs may be deemed to be repairs rather than improvements. Repairs on one’s primary residence are not deductible nor includible as part of the cost basis of the home.
Being a homeowner is easily identifiable. Distinguishing between a dealer and an investor, however, is not clearly defined by the tax code. A real estate dealer is a person who buys and sells real property with a view to the trading profits to be derived. Their operations are so extensive as to constitute a separate business. A person acquiring property strictly for investment, though disposing of investment assets at intermittent intervals, is generally not regularly engaged in dealing in real estate.
This issue has been debated in the tax courts frequently. Both the IRS and the courts have taken the following into consideration:
- Whether the individual is already a dealer in real estate, such as, a real estate sales person or broker;
- The number and frequency of sales (flips);
- Whether the individual is more committed to another profession as opposed to fixing and selling real estate, and
- How much personal time is spent making improvements to the “flips,” as opposed to another profession or employment.
The distinction between a dealer and an investor is truly based on the facts and circumstances of each case. Clearly, an individual who is not already in the real estate profession but flips one house is not a dealer. One, who flips five or more houses and/or property with substantial profits, would probably be considered a dealer. Everything in between becomes these various shades of grey. The facts and circumstances of each case must be considered.
If you have questions, contact the Tax Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
