A full-time real estate flipper, or what the IRS considers full-time, may not qualify for the lower capital gain tax rate and instead be taxed at the ordinary income tax rate. A real estate flipper buys real estate, rehabs it and then sells within a short time. It is the opposite of a buy-and-hold real estate investor. If you are not considered a real estate investor, you may not defer paying tax by taking advantage of an exchange for a like kind property. 100% of your net profit from your real estate flipping will be taxed as income in the year of the closings, even if all of your net profit applies to the purchase of another parcel of real estate. To pour salt into the open tax wound, a dealer will also have to pay self-employment tax at the 2014 rate of 15.3%.
If the IRS labels you as a dealer, and you are also a landlord, the IRS may argue you are subject to ordinary income tax rates on the net profit from the sale of real estate you have owned for years. What is a real estate flipper to do? You may own rental homes in an LLC taxed as an S-corporation. Your rental income passes through to your individual income tax return. If the IRS labels you as a dealer, the adverse tax impact applies to the property owned by the LLC only, not you personally. There is another benefit to doing this: asset protection. If the LLC is sued, real estate owned by the LLC is at risk only, not your rental property which is held in another LLC.
If you think you are a dealer and believe you can report your income as you receive it in an installment sale, that option is not available. You may have a tax bill due on the entire net profit from your closing and only receive a small part of the gain each year.
How do you lawfully avoid the unwanted designation as a dealer? There are no set-in-stone criteria used by the IRS to designate a taxpayer as a dealer and not a real estate investor. The IRS looks at all of the circumstances.
Examples of the criteria the IRS might use to assign dealer status:
- How much real estate do you buy and sell each year?
- How long do you usually hold a property?
- Do you make major capital improvements to the property you buy?
- Do you obtain favorable zoning law changes while you hold the property?
- Did you subdivide the property?
- Do you maintain a sales office?
- Do you maintain a sales staff?
- Do you collect significant rental income?
- Is real estate your full-time job or do you receive income from a full-time job doing something else?
- Are you actively involved in the renovation and sale of the real estate you buy?
- How do you advertise?
If your are designated as a dealer by the IRS, it may not be as bad as you may first think. There are advantages to being classified as a dealer. Any losses you experience are treated as ordinary losses, not capital losses. Ordinary losses can offset more ordinary income than a capital loss. If you are a dealer, the losses are business losses and therefore deductible.
The exception to the above is if you have your real estate in a self-directed retirement account. There is no income tax or capital gain tax on the net profit from your closing if you are a real estate flipper using your self-directed retirement account. This is so if the net profit from your closing remains in your self-directed retirement account. This also assumes you did not use borrowed funds to purchase the real estate with funds from your self-directed retirement account.
Before you flip out over the tax treatment of your real estate buying and selling, discuss a tax plan with your tax advisor and attorney to lawfully allow you to be treated as a real estate investor. If you are truly a real estate flipper and consequently labeled as a dealer by the IRS, you may still lawfully contain your dealer status to a legal entity, such as an LLC, so your dealer status will apply only to the real estate owned by the LLC. This article is for general information only and is not intended to provide legal or tax advice. If you have questions or concerns about a real estate flip, please call us at 813-852-6500 for a free 30-minute consultation with a Florida real estate attorney.