Table Of Contents
In this episode, Brandon Hall & Thomas Castelli discuss how the tax treatment of flipping properties differ from the more favorable tax treatment of rental properties.
This episode is sponsored by our free Tax Smart Investors Facebook Group.
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.
Thomas Castelli 0:00
You're now listening to the real estate CPA podcast.
Brandon Hall 0:04
Your source for all things real estate, accounting and tax. Here we reveal our secrets that can save you 1000s in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business, and how they steer clear of Uncle Sam.
Thomas Castelli 0:30
Hi, everyone, thanks for tuning into this episode of The Real Estate CPA Podcast. Today we're gonna discuss how profits from flipping houses are taxed, starting with the dealer status and why the dealer says can subject you to ordinary income tax rates on your flips. Most real
Brandon Hall 0:46
estate investors, at least in our network are considered investors. But a lot of people make the mistake that that they think that because they are a real estate investor or they believe that in their own eyes, that they are a real estate investor that whenever they go and do a flip, whether it's a land flip, or like an actual tear down rebuild, or big gut rehab, you know, whatever you're flipping, that you get to enjoy the same benefits of an investor. And I'll tell you where the big mistake typically lies is you've got like a landlord that, you know, has a handful of rental properties. And they know that if they hold a property for 12 months, they're gonna get long term capital gain treatment. So they go start flipping properties, and they hold their flips for 12 months before they sell them. And then they think that because they've held them for 12 months, they get capital gain treatment. But what we're going to go over today is why that's not necessarily the case, and how a lot of people doing that end up shooting themselves in the foot, or get caught under audit where it gets really painful, really fast.
Thomas Castelli 1:51
Yeah, basically, what we have to break down is whether or not you're in the business of buying houses, renovating them, and then basically reselling them right away, or you're in the business of buying properties and holding them for rent. And what's the criteria for being basically a flipper for lack of a better word, right. And that's called dealer status and the terms the IRS uses. So basically, what it comes down to, there's a bunch of different criteria that could potentially expose you to the dealer status. And that's where we kind of go through right now,
Brandon Hall 2:19
before we jump into those factors, let's talk about the differences in tax between real estate investor and real estate dealer. So if I'm a real estate investor, and I hold a property for 12 months, I get long term capital gain treatment, which means that my gain is going to be taxed at a maximum 20% tax rate, the long term capital gain tax rates, at least today, that could actually change here in a couple weeks, or even by the time this podcast comes out. But at least today, if I hold a property for 12 months, I get long term capital gains treatments, maximum 20% rate, I might have the net investment income tax, that's an additional 3.8% tax rate. But that depends on your marginal tax bracket. And I might also have depreciation recapture. But the point is, is that you get preferential treatment when it comes to taxes as a real estate investor. And if you hold the property for at least 12 months, on the flip side, not to be punny. But on the flip side, if I'm flipping property, and I'm a real estate dealer, then my tax rate on my profits is the maximum of 37%, my ordinary tax rate, so whatever tax bracket I'm in, that's the tax rate that I pay. So maximum 37% rate, I also pay a 15.3% self employment tax on the profits, and then I pay state taxes. So in certain states, you could very easily find yourself paying a 60% tax rate on the profits that you make from your flipping activity. And when you're a dealer, it doesn't matter how long you hold the property, you could hold the property for years. And you will still when you eventually liquidate that property still be subject to that maximum 37% rate and that 15.3% self employment tax. So you got to be real careful with this. And we're going to go over these factors here. But before we go over these factors, what I want to talk about is who makes a real estate dealer. So there's three main factors. And then we're going to talk about primarily for sale, which are the additional factors that Tom was just mentioning. So there's three main factors that if you meet, all three, you're gain from the sale of real estate property will be taxed at ordinary rates, your marginal tax rates, factor number one, the taxpayers engaged in a trade or business. Now what does that mean? Well, if you flip one property, and that's all you ever do, you could probably argue that you're not actually engaged in a trade or business, especially if the income coming from that one flip is insubstantial compared to all of your other income. If you earn a million dollars as a physician, and you go and you flip one random In the house and you make 10 grand, you're probably going to be able to hang your hat on the fact that you're not actually engaged in a trade or business. But if you flip one property every year, for a number of years, you're going to find that you probably are engaged in a trade or business. So you can really only in our experience, at least, you can really only skirt under this rule, if it's a one off flip, and you're never really doing it again. So the first factor, the taxpayer is engaged in a trade or business. The second factor, the taxpayer is holding the property primarily for sale. In that trader business, we're going to talk about primarily for sale, that's where all these additional factors come into play. The third factor, the sale of the property is ordinary for that business. So if you meet all three of those factors, you have ordinary income treatment, meaning that you're going to be taxed at that marginal rate, that 37% maximum rate plus that 15.3% tax. So again, those three factors are taxpayers engaged in a trade or business, the property is held primarily for sale, and the sale of the property is ordinary for that business. So let's talk about what primarily for sale means that's where these additional factors come into play.
Thomas Castelli 6:08
Alright, so when you're talking about primarily for sale, we're gonna break this down into nine factors. And basically, there's no one specific factor that the tax course will use to help determine whether or not you are a deal or not. Pretty much factors four and five will take priority and factors four and five are the frequency and number and continuity of sales, and the extent and substantiality of disposition of the property. So basically, what role are you playing in disposing of that property?
Brandon Hall 6:41
Yeah, absolutely. So factors four and five, while again, no one factors controlling and what that means is, if you flip one factor, you're not automatically going to be a dealer, but like Tom was saying factors four and five in prior tax court cases have always carried the most weight. So Tom, why don't you run through the nine factors that define primarily for sale?
Thomas Castelli 7:03
Okay, so the nine factors that define primarily for sale are number one, the purpose for which the property was initially acquired to the purpose for which the property was subsequently held three the extent of the improvements the taxpayer made to the property for that's the frequency and number and continuity sales, five the extent and substantiality substantiality of the disposition of property six, the extent and nature of the taxpayers business seven, the extent of advertising promotion, or active efforts used in soliciting buyers for the property, at the listing of the property for sale through a broker and nine the purpose for which the property was held at the time, the disposition.
Brandon Hall 7:49
So again, in order for a property to have ordinary income treatment, meaning maximum 37%, tax rate 15.3% tax, the taxpayer has to be engaged in a trade or business, the taxpayer is holding the property primarily for sale. And that sale is ordinary for that business. So those are the three main factors of what Tom just went through. He just broke down the sub factors, the additional nine factors for what primarily for sale means in the second factor that I just ran through. So Tom just went through the nine factors. And he just told you that factor four and five carry the most weight. So again, four and five, the frequency number and continuity, the sales, the extent and substantiality of the disposition of the property. So those are the two factors that carry the most weight. Now, all that said, when we have conversations with investors about this, typically they've gone to like a boot camp, they've coordinated or learn from another flipper in their area, they've gone to some sort of real estate meetup. And everybody always talks about intent. As long as you don't have the intent of being a flipper, then you're good. That's what everybody learns. So what do you do? Well, you learn to write like a little statement out that says, I don't have an intent to be a flipper. I'm a real estate investor and hold the property for a long time, yada, yada, yada. Just know that all that's BS, the IRS is not going to buy it. What they look for is objective facts, not what your thought process is or your thoughts. Now, objective facts could be recording meeting minutes, if you're part of a partnership or corporation and you're meeting on a consistent basis, recording those meeting minutes that can actually help but don't think that just sitting down and writing a little statement out about your intent for the property is going to all of a sudden make you not a dealer. So if you've been told that press pause and and go scroll back through rewind, listen to those nine factors again, and in reconsider what you've previously been taught. Now factors one, two and nine are carry the second most weight so Tom, just said factors four and five, carry the most weight for what the definition of primarily for sale means. Factors one, two and nine, carry the second most weight. And those are all about intents factor. One is the purpose for which the property was initially acquired. factor two is the purpose for which the property was subsequently held. And then factor number nine is the purpose for which the property was held at the time of disposition, but just know, again, that more weight is going to be given to objective evidence than to a taxpayers own Statements of Intent. And that was very clearly laid out by the tax court in Guardian industries Corp reverse Commissioner, it was a 1991 tax court case. So whoever's telling you write down a statement of intent. No, that's a bunch of BS.
Thomas Castelli 10:45
And we also got to take a look at the third factor that is that is going to be looked at. And that's actually factor number three, which one carries the most weight, and that's the extent of the improvements the taxpayer made to the property. So all these things to be taking into account when determining whether or not that property in question was hold primarily for sale. Factor Number
Brandon Hall 11:05
Three carries the third most weight. I think that's what you meant to say. Throw that in there.
Thomas Castelli 11:09
Yeah, yeah. No, that that is what I meant to say, yeah, no. And when
Brandon Hall 11:12
you're going through an audit with this stuff to do you ever get audited for something like this, the IRS is going to request a lot of documentation. And they're going to try to make a determination between whether or not you were actively advertising the property for sale, or like a good deal just fell into your lap. So that can often be a determining factor. When you are defending dealer status, or investor status, I should say.
Thomas Castelli 11:35
Absolutely, that's why documentation is key, you always got to keep everything documented. If you have emails, you have minutes, like Brian was saying, You're keeping corporate minutes, maybe you're using a corporation, and you need to document what your intent is that can help help, you know, prove what your intent was, and how the situation in the sale came to be. Yeah, you know,
Brandon Hall 11:55
if you want to learn more about these factors, we actually dive into them and an article that I wrote on tax smart investors.com, it is a membership site, but you can subscribe to a 14 day free trial. So go check that out if you want to learn more about the factors. But if you are a dealer, you report your flipping activity on Schedule C, and you don't report it on Schedule D, that's a big mistake that we see a lot of people make, they try to report as capital. That's where that's where you report that that's why you report on scheduled days, because you're reporting capital gains, rather than business income. And if you're flipping property, it's not capital, you don't have a capital asset. At that point, it's treated like inventory and should be, should be put on Schedule C, all profits are subject to your ordinary tax rate. And that 15.3% self employment tax, the NOC going to be on schedule D. So don't do that don't don't go through your flips, and Schedule D, if you are in the trade, or business or flipping because you're just gonna expose yourself to a pretty nasty audit. But on Schedule C. So you're going to report your your gross income as just the total sales price, total sales price plus any, any allowances that you've received from buyers or whatever, that's going to be your gross income number, you're then going to back out the cost of the sale, as cost of goods sold technically, on Schedule C, that's we're going to we're going to report all the costs. Now what are all the costs? Well, the costs are going to be original acquisition price, it's going to be the improvements, any direct costs and indirect costs that you allocate into this property. So you gotta have really good accounting in place as well. We do a lot of accounting for flippers, and it's life changing, because they can finally track everything and their tax returns start making sense. But you got to have really good accounting, and you're going to end up with a net income number. But on that cost of goods sold piece of mistake that we've seen people make is, let's say that I say I buy a property in December. So I spent $100,000 on a property. It's December, I don't actually sell the property until January. Where do I report the costs of that property? Where do I report the cost of that property?
Thomas Castelli 14:04
You're not reporting it, you're not reporting it in that year, you're really holding it as inventory on your balance sheet until the point in time when you do sell, and then it becomes cost of goods sold. So everything kind of gets capitalized capitalized, really just gets held as inventory on your balance sheet until the time comes when it's time to sell.
Brandon Hall 14:20
Right, right. Yeah. So So we've seen people, the duck the entire cost, even though they're still holding the asset at the end of the year. So in this example, let's say that I bought a property for $100,000. December 1, I put $50,000 in before December 31. And I sell it on January 2, because nobody does transactions on New Year's. So on January 2 for 200k. Why don't report the 200k on this year's tax returns because I sold it next year. I sold it in January of next year. So the 200k is going to go on next year's tax returns. The 150k my purchase price plus my 50k of improvements should also go on next year's tax returns. But we see people make the mistake of deducting the 150k a day. So what does that make? What does that mean? Well, their schedule C shows a big loss shows $150,000 loss, business loss, and they're all happy. Because it reduces their taxable income, they get a big tax refund. But guess what, next year, what are you gonna show you're gonna show $200,000 business income, now, you're gonna have to pay a lot more in tax. Just because you don't have any cost to offset it, you wrote the costs off in the prior year, that is incorrect treatment, you have to get the match your costs to the revenue. So the correct treatment would be reporting the 200k sale next year as well as the $150,000 of costs. Next year, you would report no costs, or maybe very minimal holding costs, indirect costs this year, on your tax terms, you wouldn't report the direct costs and the indirect costs that have been allocated to that property until you sell it until you sell it.
Thomas Castelli 15:54
Yeah. And remember, you're going to want to make sure you do that. Because if you have a huge profit, and you float off the property last year, that might push you into a higher tax bracket, because these aren't reported at the capital gains tax rate. So you don't get that preferential treatment. So like, if you have a huge sale, like a million bucks, that could easily push you into the 37% tax bracket. And you want to make sure you can deduct the costs against the target that profit down where it should actually be. So you're not pushing yourself into a higher tax bracket. The point I'm trying to make here, it's just all the more reason to make sure that you're reporting this properly, because the tax could be so high for you.
Brandon Hall 16:30
And just to close this out, I would love to run through actual numbers of the tax could be extremely high for you. So I want to run through that last statement. So let's assume that I buy a property, and I put x dollars in, and I've got $100,000 of built in gain. And let's say that I sell the property. Now I'm a dealer, I mean, the three factors in that I'm engaged in trader business, I'm holding the property primarily for sale in that trader business, in the Properties ordinary for that trader business. So I meet the three factors. I'm a dealer, I've got $100,000 of gain. Now what taxes Am I exposed to well, I've got the 37% margin, let's say I'm already in the 37% tax bracket, and then I do this flip. Now I've got a 37% tax rate on the $100,000. So that's $37,000. I also have that 15.3% self employment tax. So that's another $15,300 Which means that my federal taxes are $52,300 on my $100,000 of income. And I live in North Carolina, where our top tax rate is 5.25%. So that's another $5,200. So after all is said and done, my total taxes between federal and state, is before any ancillary things come into play, my total taxes on this $100,000 is $57,550. Which means that my after tax profits are only $42,450. So the government gives me the privilege of flipping homes, but then they tell me that I've got to give them almost 60% of my net profits, which significantly reduces my ability to roll that cash back into new pot, you can't 1031 Exchange flips, so I can't I can't avoid that way we're going to talk about on episode three, how to avoid these taxes if you're a flipper, so make sure that you watch or listen to all three of these episodes. But it's a significant tax that's really difficult to avoid. And it's painful. But if I'm an investor, if I'm an investor, and let's say I am in the 37% tax bracket, I'm going to pay the 20% long term capital gain tax rate on my income. I'm also going to pay the 3.8% net investment income tax rate on my income because I am in the 37% tax brackets now I am subject and 37% is not the threshold is $250,000 of modified adjusted gross income. If you're above 250k, modified adjusted gross income, you're subject to that 3.8% net investment income tax on your investment earnings. If I'm an investor, now I have investment earnings, the capital gain income is subject to that net investment income tax, whereas the flipping income is not because it's not capital in nature. It's a trader business so I don't actually have to pay that 3.8% net investment income tax on my flip income. What I do when I sell a rental property so I sell a rental property for $100,000. I pay a 23.8% tax capital gain tax. I also paid the North Carolina maximum tax rate of 5.25. So my total tax rate on this is 29% Roughly, which means that my total taxes are $29,000. So when I back that out from my $100,000 of gain my after tax cash that I get to pocket is $71,000 About $30,000 higher than if I'm a flipper. So it definitely pays to be an investor. But what we're hoping that you're going to take away from this series is that you can't just write a statement of intent. And think that all of a sudden, you're not a dealer, you've got to really structure your fax, to make sure that you protect yourself from any sort of audit. And and you got to make sure that you report these things the right way.
Thomas Castelli 20:25
Absolutely. And you know, something else is coming up the pipeline, and we'll discuss this later is that under the Biden's proposed tax changes, that top bracket might go back to 39.6%. And now you're gonna have another 2.6% tax on top of that 37% tax bracket. So there's all the more reason to you know, take this stuff into consideration and make sure that you plan out your business to put yourself in the most tax advantageous position possible. Hey, everyone, thanks again for tuning in today's episode. Before you go, we do want to remind everybody about the tax smart real estate investor Facebook community, with over 2500 members and counting. There are a ton of great conversations taking place right now between real estate investors of all levels. And with the buying tax changes in the pipeline. This is something you're not going to want to miss out on to join go to wwe.facebook.com/tech smart investors, or search for tech smart investors on Facebook to join today.
Brandon Hall 21:20
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