Small Business Taxes & Management^TM--Copyright 2015, A/N Group, Inc.

Introduction

Thinking of "flipping a property"? Grab a foreclosure for peanuts, throw some paint on the walls, some appliances and a kitchen countertop and start picking colors for the new car.

In two earlier articles Investing in Rental Real Estate--Part I and Part II we discussed a number of issues to consider if you're interested in a buying a property for rental. Some of the tips in those articles apply here and you should read those in conjunction with this one. This article is primarily about the tax issues you may encounter, we'll take a quick look at some nontax ones first.

Economics

Buy low and sell high! Good advice in the stock market and it applies equally well in real estate. Easier said than done.

The first step is finding a property. You may get lucky, but doing a bunch of legwork is more common. If you're flipping you want to turn the property around as quickly as possible. That generally means buying in an attractive location or at least getting a property that's a bit more attractive than others in the neighborhood.

You also want to get a property with a minimum of surprises. You expect to replace plumbing fixtures, some wiring, much of the kitchen. But you don't want to deal with mold, zoning issues, asbestos, lead paint, etc. The location of the property is important here. Abandoning an oil tank in some localities may be as low as $1,000; in others as high as $15,000--and it doesn't add eye value to the property. Unfortunately, with foreclosures you may not have much of a chance to evaluate the property.

Foreclosures can have hidden legal problems too. In some states the "owner" has considerable power to stop the transfer of the property, or there can be liens on the property. A real estate attorney can be invaluable here.

If you don't have experience and your brother isn't a contractor, you'll need considerable help in estimating the cost to complete. That's the second critical step. Demolition can be more costly than you might think. Sheetrock and paint can be easy and cheap; if you need a licensed plumber and electrician, the price goes up quickly. Permits and architect's work can add time and cost.

Get your best estimate for the renovation work and add at least 30%, more if it's a big project, there's a lot of work to do, or you're inexperienced. And do a budget before starting. It'll help you avoid the urge to add "features" that can balloon the cost.

Tax Issues

Clearly you'll have to pay tax on any profit you make from flipping a property. But there are more issues here than just that. Here are some points to consider.

Type of Entity. If you're going it alone, it's a one-shot deal, and you're fully insured, you may not want to create a special entity for the project.

On the other hand if you're going into the project with one or more partners, you'll need an entity for tax purposes. Even if you don't set one up, the law assumes you're in a de facto partnership. Clearly, it's better if you choose the type of entity rather than have the IRS pick one for you. An LLC is usually the best option because it affords the limited liability of a corporation, but allows you to allocate profits and capital relatively freely. For example, Fred and Sue buy a run-down property. Fred puts up $90,000, Sue only $10,000. But Sue's an architect will be doing most of the work. Fred and Sue have agreed that after Fred recoups his investment plus a 10% return, the profits will be split 70% for Sue and 30% for Fred.

Fred and Sue could have set up an S corporation, but it might have been difficult to achieve a similar payoff for the partners.

While an LLC is usually the best choice, that's not always true. Talk to your tax advisor before committing.

Capital Gain or Ordinary Income? It would be nice if you could do the work, hold the property for more than a year, sell it, and report the gain as a long-term capital gain and pay taxes at 15% or at least no more than 20%. But whether that's possible or not depends on whether the circumstances. A little background is in order. If you hold a property for investment and sell it at a gain, you've got a capital gain--short-term or long-term depending on the holding period. On the other hand if you're in the trade or business of dealing in property (e.g., a contractor) and sell the same property for a gain, it's ordinary income.

It gets trickier. Sue's a contractor, sometimes rehabbing buildings, sometimes buying land and constructing houses or small commercial buildings, and sometimes buying properties to hold for investing. She owns several commercial buildings she constructed and rents. Should she sell a property she just rehabbed, the profit will probably be ordinary income. If she sells one of her rental properties, it'll probably be capital gain. So how do you tell the difference? Tax law has come up with seven factors the IRS and the courts will usually examine to determine which category the sale fits. The factors include:

1. the frequency and regularity of sales of real properties;
   
2. the substantiality of the sales and the relative amounts of income taxpayers derived from their regular business and the sales of real properties;
   
3. the length of time the taxpayers held the real properties;
   
4. the nature and extent of the taxpayers' business and the relationship of the real properties to that business;
   
5. the purpose for which the taxpayers acquired and held the real properties before sale;
   
6. the extent of the taxpayers' efforts to sell the property by advertising or otherwise; and
   
7. any improvements the taxpayers made to the real properties.

The factors are designed to indicate the intent of the taxpayer. In the example above, Sue will probably always be considered a dealer with respect to factors 1, 2, 4, and 7. But factors 3, 5, and 6 could be in her favor. For example, Sue purchased a run-down commercial building, rehabbed it and rented it for several years. She never advertised the property for sale, but a tenant made her a generous offer and she took it. Those factors probably outweigh the others and it's very likely a court would hold that any gain would be capital in nature.

What if you're flipping properties? Most of the factors will favor ordinary income treatment. The only ones that might be in your favor are 1 and 2. For example, Fred and Julie uncover a foreclosure in their neighborhood and rehab the property. It's their first time and both Fred and Julie are employed. More than likely, any sale will be capital gain in nature.

Where's the turning point? To that there's no easy answer. The first property sale should probably produce a capital gain. But after that showing you're not in the trade or business of flipping could be more difficult. You may be on safer ground if the projects are occasional rather than continuous.

You can increase your chances of capital gain treatment if you change the property, at least for a couple of years, to a rental or other income-producing property. But that's likely to work only for a small number of properties.

Self-Employment Tax. If the IRS or courts determine you're in a trade or business not only are the profits ordinary income, you'll most likely be subject to the self-employment tax if you're operating as a sole proprietorship, LLC or partnership. If you're operating as an S corporation you should be paying a salary to the officers which is subject to FICA. Depending on your status for FICA (over or under the Social Security threshold) the self-employment tax can significantly cut into profits.

Installment sale. If you're an investor in a property, you can sell it on the installment method. That is, spread the gain over a number of years. That can be an attractive option in keeping your taxes low and, possibly, taking the gain in year when you're in a much lower tax rate. However, if you're a dealer you can't use the installment method. And the same factors will be used to determine that status as discussed above. (Some special rules apply to land held by dealers.)

Like-Kind Exchange. Similar rules apply to like-kind exchanges. If it's a rental (or other productive use) or investment property, you can do a like-kind exchange. But if the property is held primarily for sale to customers, like-kind exchange treatment is denied.

Final Advice? You can make money, absent any tax advantages, if you're good at rehabbing. But there may be easier ways to make money. Beside the construction aspects, you'll also be investing a considerable amount of money. That increases the risk. Get good advice before attempting, and talk to your tax advisor.

--Last Update 04/22/15