Counseling Clients on the Tax Consequences of House Flipping
House flipping is not always done on a consistent basis or as a primary means to generate income, but it's very common for CPAs to come across clients who engage in this activity.
The practice of “house flipping” carries the prospect of large profits. When someone “flips a house,” he or she buys and invests in that house for the specific goal of reselling for a profit. House flipping can be done at both the individual and the company level.
Some individuals, for instance, use house flipping as their principal way of generating income. And many companies throughout the country specializing in buying and reselling properties for a profit.
CPAs can add value for their clients who engage in house flipping by providing counsel on the types of tax treatment which may be triggered. If clients discuss their house flipping with enough notice, they may be able to alter their behavior to obtain better treatment.
Either way, clients will always benefit from knowing about the tax consequences which can follow when they buy and resell real estate. Let’s go over in detail the sort of counsel which CPAs can provide.
Two Different Types of Tax Treatment
When an individual or corporate entity buys and resells real estate, the resale will trigger one of two possible types of tax treatment. The sale will either trigger ordinary income or capital gain. In general, ordinary income means income generated in the normal course of operating a business or trade.
Capital gains, on the other hand, follow from the sale of a capital asset. Depending on how precisely a given person goes about selling real estate, that person may face either of these two types of treatment. In other words, tax treatment depends on how a given person conducts himself or herself throughout the sale and resale process.
If a person buys and sells real estate as his or her principal form of business, then that person is considered a “dealer.” These dealers face ordinary income tax treatment, however, if a person buys and resells real estate but intends to hold the property as an investment for some period of time, then that person would be considered an “investor.”
Investors do face capital gains tax treatment. Long-term capital gains tax treatment is typically much better than ordinary income tax treatment and so this determination between dealer and investor is usually quite important.
Tax Treatment Depends on a Case-by-Case Analysis
Whether a given scenario falls into either the “dealer” category or “investor” category for tax purposes requires a case-by-case analysis. No two cases are exactly alike because each case has its own set of relevant factors.
A common example of a dealer is a person who buys and sells real estate as his or her primary means of income, posts advertising, has a business office, does not hold the property long before reselling and so forth. Many companies specialize in this type of practice.
On the other hand, a common example of an investor is someone who buys real estate, improves it, holds it for a significant period of time, rents it to residential or business tenants and then eventually resells it. In this latter case, there is clear evidence that the investor did not merely intend to buy the real estate specifically to resell, but also to hold it as an investment.
It’s important to note that even those who partake in house flipping on a limited basis can still be denied capital gain treatment. For instance, suppose a person buys a house, fixes it, and then immediately resells it without making any efforts to hold it as an investment.
Even though this person would not be a “dealer,” he or she still wouldn’t receive capital gain treatment because the property was held primarily for sale, not for investment. This would still be true even if the majority of this person’s income were derived from other means.
There have been a number of court opinions which have addressed this dealer vs. investor distinction. These cases may need to be consulted depending on the circumstances. This is where a good CPA can step in and recommend a qualified tax attorney.
In edge cases, courts have applied tests to sort between dealer and investor status. These tests ultimately involve a close examination of all relevant details. It’s important to let clients know, however, that no legal outcome can be predicted with certainty and that edge cases can always be decided in any way.
Capital Assets Taxed at Short or Long-Term Rates
If a given person is classified as an investor, then that person will either face the short or long term capital gain tax rates. The short-term capital gain tax rate is currently the same as a given investor’s ordinary income tax rate. The short-term rate typically applies for assets held for less than 1 year.
The long-term tax rate can be either 0 percent, 15 percent or 20 percent depending on a person’s income and this rate kicks in when an asset is held for longer than 1 year. In some cases, these rates can be affected by other factors aside from just time, such as the case with some stock options.
When counseling clients about the tax consequences of house flipping, it’s worth mentioning that the benefit of investor status only really matters if the long-term rate applies. Given the stiff tax liabilities which can follow from house flipping, it’s only natural that these people would be curious about the consequences of this type of business.
If you’re a CPA looking to build a more loyal client base, you can take a big step in this direction by offering good counsel on the distinction between dealer vs. investor status.
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Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.