Fix and Flip Tax Business Strategy Question

[Graham Melvin]

Hello real estate investors community.  

My question is about how fix and flips are taxed.  It seems like everyone talks about turning properties as quick as possible, however it's my understanding that if you turn it in a year it's going to be earned income and you're going to have to pay FICO (14.2% for self employed) on it and it will be taxed at your top income: assuming at least 25% tax rate.  

Am I correct that if I do a fix (say in 3 months), then refi my money out of it and rent it for another 9 months so I hold it for a total of a year.  That at that point if I sell it I will only be paying long term capital gains at 15%?  

My follow on question is if the above is true: why doesn't everyone do this and pull their money out after they fix it so they have money to start another fix ever 3 months and just have rolling 12 month projects where you're leveraged for the last 9 months of it in order to lower your tax rate by ~24%?

Thanks!!

[Dave Foster]

@Graham Melvin, a property that you purchased with the intent to sell rather than to hold for productive use in business, trade, or for investment is considered inventory (note that intent is the key distinctive not time).  You may have held if for a month or 12 years as once recent court case established.  But if the IRS deems that your primary intent was to sell (flip) it you will pay ordinary income on it which will include self employment taxes as well.  It's a nasty hit but a popular one it seems.

However, you begin to describe another model that can be made to work rather well.  If you purchased property with the intent of holding it for productive use and then fixed it, put a renter in it, and refi'd it to get your next property then you are probably in safe territory to treat it as a capital asset andsell after a year and get cap gains treatment.  Just remember it's all about your intent and holding period is only one of ways you establish intent.

The other option that @Aaron Howell refers to is the opportunity to not just get capital gains treatment on a sale but actually defer paying the tax entirely by doing a 1031 exchange - sell a piece of investment property that you have held for productive use and using a specific process purchase another piece of investment property that you also intend to hold for productive use.  When you do this the tax you would ordinarily pay is deferred and you are actually using that tax to purchase more investment real estate.

But it's the same story - your intent when you buy your property must be to hold for productive use not primarily for resale.  There's no statutory holding period but conventional counsel over the years has been to hold it for more than a year and you're OK.  But there seems to be a developing awareness in that even if you've held it for more than a year you want to  make sure you haven't exhibited any behavior that would lead someone to thing your intent all along primarily to resell.