With the rise of reality TV shows like Flip or Flop and the increased interest in HGTV, public interest in property flipping is at an all-time high. Last year, this interest manifested itself into reality. Based on statistics from ATOM Data Solutions, the rate at which homes are being flipped has reached a 14-year high.
Investors are also receiving an increased rate of return from their fixer uppers. So it's no wonder the market is booming. While this investment strategy can be lucrative, it does not come without some significant tax implications (i.e., the house flip tax). You should review these with your tax advisor before the May 17 filing deadline.
Tax treatment of fix-and-flips
The tax treatment of your fix-and-flip investment hinges upon whether or not you're considered to be an investor or a dealer for tax purposes. While there is no hard and fast rule to distinguish between a dealer and an investor, in a series of cases, the tax court has consistently looked at certain factors to determine who is an investor and who is a dealer.
You should note that this is a heavily litigated issue, so working with an advisor before acquiring a property is advisable. An advisor can work through the case law with you to determine whether or not you're a real estate investor or a real estate dealer.
Real estate dealer
In general, to arrive at the conclusion that an individual is a real estate dealer, the court has consistently looked at the following factors:
- The property owner’s intent: whether the property has been acquired during the ordinary course of business.
- The frequency and sustainability of the sales.
- The degree of solicitation, advertising, and sales activity.
- Sustainability of transitions.
- Duration of ownership: nature and purpose of property ownership.
While the above list is not exhaustive, the court generally looks at the above factors. The court may also look at other factors, such as whether the owner has control over the property and the location of the business office.
If the court determines that you are a dealer, you will be exposed to less-than-favorable tax treatment. At the federal level, dealers are taxed at the ordinary income tax rates. In addition to being taxed at the ordinary income tax rates, real estate dealers are exposed to self-employment taxes. The self-employment tax applies to your net earnings. At present, the self-employment tax rate is 15.3%. At the state level, dealers will also be exposed to state income tax.
Real estate dealers are also barred from completing a section 1031 exchange (the property must be held for investment purpose) and they are also prohibited from completing a section 453 installment sale. Dealers also can not claim the depreciation deduction and may also be required to capitalize their expenses instead of deducting them in the current tax year.
As you can see, being classified as a real estate dealer is the least-beneficial tax status. For this reason, working with an advisor before acquiring the property is essential.
Real estate investors
Unlike real estate dealers, real estate investors are able to enjoy the more-favorable capital gains tax treatment. Capital gains are classified as either short-term capital gain or long-term capital gain.
Short-term capital gains taxation
Assets are classified as short-term assets and thus taxed at the short-term capital gain rate when an investor holds the asset for less than a year. Upon disposition, the gains from the assets are taxed at the ordinary income tax rates. This is not the most favorable tax treatment because the ordinary income tax rates can go up to 37 %. That is a significant amount of taxes to pay when your main goal as a flipper is to maximize your gain. The ordinary income tax rates for the current tax year 2021 are as follows: