15 Aug Dealer’s Trap
If you flip a lot, there’s no avoiding it. The more deals you do, and the more you rely on income received from the flipping business, the more obvious it’s going to be that you’re running a flipping business.
If you’re only doing a few flips per year, though, or if you don’t rely on the income received from flipping, you have more options. But first, let’s take a look at some technical tax stuff.
Capital vs. Ordinary Assets
A capital asset is an asset held for investment, rather than for profitable resale as soon as possible. These assets, if you hold them longer than a year, generally qualify for long-term capital gains tax rates, which max out at 20 percent for individuals with incomes over $400,000 and couples over $450,000.
My heart breaks for you.
For those in lower tax brackets, capital gains tax on long-term holdings max out at 20 percent.
For those earning less than $36,250 (single), $48,600 (heads of household), or $72,850 (married couples), there’s no tax on long-term capital gains – on capital assets.
In every case, that capital gains tax is lower than the marginal income tax bracket for the taxpayer. The law is designed to encourage long-term investment. Congress realizes that you do take on risk when you buy a capital asset, and favorable tax rates like this generally encourage investment, which stimulates building, creates wealth and leads to job creation.
The second an asset becomes inventory, rather than a capital asset, though, you get stuck paying the 15.3 percent self-employment tax. Yes, you are your own employer, which means you get to pay both halves – the employer and employee halves – of your taxes. That’s right off the top of your profits. Then you pay ordinary income tax on what’s left.
The asset also doesn’t qualify for tax-deferral under Section 1031 “like kind exchange” rules, – if you’re into that sort of thing. We don’t judge.
Most of the time, flips occur within a year, and within the same calendar year. So in practice, the difference between the short-term capital gains rate and ordinary income tax is roughly a wash.
But here’s where you can get really clobbered by dealer rules: Suppose you hold a house for sale, and you use the accrual method of accounting (which you probably should). You buy a home for $160,000, fix it up, put it on the market for $200,000 and bang! You find a buyer! The problem: She wants to owner-finance it, and she can’t get regular financing. Maybe the seasoning rules are getting in your way, or maybe she has normal-people credit … which in the post-recession era isn’t good. At any rate, you strike a deal and she pays you $3,000 down and finances the rest each month.
The problem: She gives you the down payment in December. Which means you have to book the whole sale that year? That’s right: The accrual method forces you to recognize revenue, even if you don’t have the cash yet. If you’re in the 25 percent tax bracket (ignoring the repair/renovation/selling costs for the moment), you now have a $10,000 income tax bill (plus an additional $1,530 in self-employment taxes. But you’ve only received $3,000 to pay it with. The rest has to come out of your hide, somewhere, or you have to borrow it.
(Special rules apply to dealers of residential lots, which are beyond our scope here.)
On the other hand, as long as the IRS considers the property to be a capital asset, rather than inventory, then you can qualify for installment sale treatment. This means you pay taxes on the money as you receive it (unless you opt out), in accordance with IRS Publication 537 – Installment Sales.
In a nutshell, you allocate a small portion of the payment you receive to interest, based on the market rate, and pay income taxes on that. The rest – the vast majority of the payment, except on very long loans – is taxed at capital gains rates. This is normally much more advantageous to you, the investor.
The general rule is that if you hold property for sale to customers in the ordinary course of a trade or business, you’re acting as a dealer, and therefore your activities in this regard will fall under dealer rules.
The problem is that there is no hard-and-fast line I can point to that says, “If you adhere to A, B and C, then the IRS will definitely consider you an investor rather than a dealer.” That’s true for the tax pros in town, too. But we do know the factors the IRS takes into account:
- How many deals per year do you do? If you flip just one or two houses per year that indicates that you’re not a professional dealer. Real estate is just a sideline for you.
- Do you have an outside job? If you flip properties while continuing to work full time, the IRS is less likely to consider you to be a dealer. Unless …
- Is your full-time job in the real estate business? If so, then the IRS is more likely to consider your profits to be ordinary income, just like you were operating a retail store selling houses out the back.
- Are your improvements to property you own substantial? You’re more likely to be classified as a dealer.
- Are you acting as an agent for the buyer? The flip profits are probably ordinary income.
- Do you keep a business office open for the purpose of selling property? Do you have employees or agents presenting or selling property for you? If so, the IRS is more likely to classify your properties as inventory.
- Did you hold the properties longer than a year? If so, you’re probably an investor, rather than a dealer.
That said, the presence of any one factor is not generally enough to get you cast into the dealer pit. If they are present in combination, however, you may well get classified as a dealer.
So how can you avoid getting ensnared in dealer tax rules?
Entities. Instead of selling a house, sell an LLC or S corporation that owns a house. See how that works? This won’t insulate you entirely from dealer tax. But it will help to isolate your properties, so that other properties you own aren’t affected by other properties. This sets you up to start using the second strategy, below.
Segregation. Keep your rentals separated from your flip properties, via the use of entities. If you had owner-financed a property that exists within an LLC or S corporation that only holds rentals, and never flips, then you wouldn’t have much trouble qualifying for the favorable capital gains tax treatment as an investor – and preserve your 1031 privileges as well. This strategy, incidentally, proved successful in Phelan vs. Commissioner. In that case, the IRS attempted to argue that because the same partners had engaged in dealer-type activities in other entities, the same treatment should accrue to a new entity they formed. The court noted that the IRS had recently argued precisely the opposite in another recent case, and rejected the IRSs claim, stating that as long as there was a bona fide business purpose to the entity over and above the isolation, that the segregation was valid, and could serve to protect investment actions in one entity from being “tainted” with dealer actions in others.
You can also try to insist on getting a down payment sufficient to cover taxes on an owner-financed property. That’s not easy, though. If the buyer could afford a big, fat down payment high enough to cover your tax expenses, they’d probably be able to finance it themselves.
One last note: Beware of gurus selling legal talismans. There is no single phrase you can put in your partnership or LLC operating agreement or S corporation bylaws that magically makes all your flips eligible for capital gains treatment. While such language can help you at the margins, if challenged in court, you should generally assume that IRS agents and tax court judges are as smart as you are, and will see through such attempts to disguise or distract from your true activities. What matters most is how you actually go about your business – not the language in a document in a binder on your shelf.
Can you avoid being classed as a dealer altogether? If you’re an active flipper, probably not. If you flip more than a few homes a year, you’re going to have to accept that you’re in the business of buying and selling inventory, just like the shoe-store owner down the street. But by keeping a non-real estate side job, and adhering to the other ideas here, you might be able to eke out a few more deals before the IRS lowers the boom.