Flipping Homes - A Reviving Trend in Real Estate
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 period of time. 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, who will be waiting to take his share of any profits in taxes. (And most likely, Sam's cousin in your state capitol will also expect a share, too.) Taxes play a significant role in the overall transaction, and 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% ), and 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 will generally pay significantly more tax on the profit than an investor. On the other hand, if the flip results in a loss, the dealer would be able to deduct the entire loss in the year of sale, which would generally reduce his 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 out the property while trying to sell it, and are beyond the scope of this article.
- Homeowner - If the individual occupies the property as his primary residence while it is being fixed up, 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 gain 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 fix-up costs may be deemed to be repairs rather than improvements, and repairs on one's primary residence are not deductible nor includible as part of the cost basis of the home.
This issue has been debated in the tax courts frequently, and 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.
If you have additional questions or need assistance with your specific situation, please give this office a call.
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