Tax Implications of Flipping Partnership

[Jessica S.]

I'm planning to partner with a friend on two flips in 2014. We will each be contributing equal amounts of money to the projects. Since I only anticipate doing two flips next year I'd prefer to declare the profits as investment income on my tax return rather than business income. Would the partnership preclude me from doing this? Can we just divide the sale prices and cost basis' in two for our respective tax returns?

If that isn't possible, what are our alternatives?

These will be cash purchases so it would be possible to form an LLC instead of a partnership. Would that be advantageous from a tax standpoint?

Thanks for your help

[Dave Toelkes]

Generally speaking, an LLC and a partnership are pass-through entities which means that they don't pay taxes to the IRS in their own right, but instead, the tax liability is passed through to the owner(s) personal tax return(s). A pass-through entity is tax neutral which means that the profit from your flipping activity will be unaffected by the presence or absence of the pass-through entity.

Now that you see that the actual form of the pass-through entity has no effect upon your taxes, let me clarify what it means to the IRS for your entity to be an LLC or a partnership. The LLC is created under state law and governed by state law. The federal government does not recognize the LLC as a taxable entity. Instead, the IRS requires you to treat the LLC (for tax purposes) as a corporation, as a partnership, or as a sole proprietor. Since you will be in business with a partner, your choices for the LLC tax treatment are partnership or corporation. As far as federal income taxes are concerned, you prepare the exact same tax return for a partnership as you would for the LLC treated as a partnership for tax purposes (Form 1065). So, the answer to your second question is, NO; from a tax standpoint, neither the LLC nor the partnership has an advantage over the other.

Your third question is whether you have any option on how to treat income. The IRS has rules that dictate the tax treatment in accordance with the character of the income. Even though you plan to only do two flips next year, you are in a property flipping business. A property flipping business is an active income business which means the income is ordinary income NOT investment income. It does not matter what entity you use to earn that income, the income is ordinary income and will be taxed that way when passed through to Schedule C of your personal tax return.

As to the allocation of income, you and your partner will each pay taxes on your respective share of the partnership income. Whoever prepares your Form 1065 will also give each of you a Schedule K-1 which allocates your respective share of the partnership income to be reported on your personal tax returns.

Suggest you consult your own CPA for more specific details related to your own unique circumstances. Suggest your attorney also be intimately involved in the discussions about which entity is best for your situation.