Is interest received from fix & flip loans subject to self employment tax?

[Cindy Auch]

Wanting to understand how the interest part of our income (partnership LLC) for short term loans- mostly fix & flips, are considered for tax. One accountant said it's not subject to self employment tax since it's considered passive (but origination fees and other loan income fees are subject to it. Another accountant said it's ordinary income subject to SE tax since we're a partnership LLC. Also anyone have insight on excess taxable income regarding the above and private lenders? Thanks

[Sean Graham]

Quote from @Cindy Auch:

Wanting to understand how the interest part of our income (partnership LLC) for short term loans- mostly fix & flips, are considered for tax. One accountant said it's not subject to self employment tax since it's considered passive (but origination fees and other loan income fees are subject to it. Another accountant said it's ordinary income subject to SE tax since we're a partnership LLC. Also anyone have insight on excess taxable income regarding the above and private lenders? Thanks

In regards to interest income, it depends on if you’re active or passive. Active is subject to SE tax. Passive is not. It depends on your level of participation.

Origination fees and other fees are typically considered active income and subject to SE tax.

[Michael Plaks]

Quote from @Cindy Auch:

Wanting to understand how the interest part of our income (partnership LLC) for short term loans- mostly fix & flips, are considered for tax. One accountant said it's not subject to self employment tax since it's considered passive (but origination fees and other loan income fees are subject to it. Another accountant said it's ordinary income subject to SE tax since we're a partnership LLC. Also anyone have insight on excess taxable income regarding the above and private lenders? Thanks

It depends. I'm sure you heard this a lot, but it is true.

Interest could either be "portfolio income" or "ordinary business income." It is decided on the partnership level and depends on whether this interest is incidental to your main business or it IS your main business, as well as the overall activities of the partnership, number of loans etc. It is case-by-case.

If it is portfolio income, it is reported on Line 5 of your partnership's K1, and there is no self-employment tax. 

If it is ordinary business income, it is reported on Line 1 of your partnership's K1. Whether or not there is a self-employment tax attached is based on whether or not you materially participate in this business. The concept of material participation is not simple, unfortunately. Basically, if you run it hands-on and spend significant time doing it - probably there is material participation and self-employment tax.

As you can see, a generic yes/no answer is impossible for your question. It can only be answered after a detailed discussion of your business. Even after that, there could be different interpretations by different accountants.

[Basit Siddiqi]

As Michael said, it depends on if you got to the level of a trade or business when it comes to lending.

Some important things that will determine this are
1) The amount of loans you are originating on an annual basis
2) What your intent is when forming this partnership
3) The value of the loans you are originating compared
4) etc

Best of luck

[Chris Seveney]

Quote from @Cindy Auch:

Wanting to understand how the interest part of our income (partnership LLC) for short term loans- mostly fix & flips, are considered for tax. One accountant said it's not subject to self employment tax since it's considered passive (but origination fees and other loan income fees are subject to it. Another accountant said it's ordinary income subject to SE tax since we're a partnership LLC. Also anyone have insight on excess taxable income regarding the above and private lenders? Thanks

 Not a CPA but every loan we have done has always been taxed at ordinary income rates.I let my CPA figure all of this out. 

[Andrew Strauss]

Hi Cindy - It depends and difficult to provide detailed answer without evaluation of specific situation as SE tax hinges on whether your income is classified as active or passive.

[Account Closed]

Quote from @Cindy Auch:

Wanting to understand how the interest part of our income (partnership LLC) for short term loans- mostly fix & flips, are considered for tax. One accountant said it's not subject to self employment tax since it's considered passive (but origination fees and other loan income fees are subject to it. Another accountant said it's ordinary income subject to SE tax since we're a partnership LLC. Also anyone have insight on excess taxable income regarding the above and private lenders? Thanks

Hello Cindy! 

As others have pointed out, interest income from a partnership can be classified as either "portfolio income" or "ordinary business income," depending on factors such as the nature of the partnership’s activities, the number of loans, and whether the interest is incidental to your main business or a core activity. Portfolio income, reported on Line 5 of the partnership’s K-1, is not subject to self-employment (SE) tax. However, if the interest is considered ordinary business income, it is reported on Line 1 of the K-1, and SE tax may apply based on your material participation in the business. If you are actively involved in running the business, originating loans, and spending significant time managing it, you may be considered materially participating, which subjects you to SE tax. Origination fees and other similar fees are typically treated as active income and are subject to SE tax. Key factors in determining the classification include the volume of loans, the partnership’s intent, and the loan values.

To prevent interest from being subject to SE tax and keep it classified as portfolio income, you can limit your level of active involvement and ensure the interest is incidental to your business, rather than the primary focus.

[Cindy Auch]

Thanks for the very helpful answers!

[Cory Vitale]

@Cindy Auch As others here have indicated, this is one of the more involved questions for those earning income as private lenders."It depends" rings particularly true. 

In my experience with a specific client of mine, it can often be challenging to make the case for passive income (therefore SE tax avoidance) if you are also a real estate investor doing your own flips. This could bring real estate dealer status into the equation under some circumstances. As @Chris Seveney@Chris Seveney points out above, often the income winds up being ordinary and subject to SE tax. Depending on your level of income from those investments, you could be better off biting the bullet and accepting the ordinary income classification while exploring SE limiting strategies like forming an S-Corp. Hope this helps!

[Ashish Acharya]

Interest income from fix & flip loans is typically considered passive income and not subject to self-employment (SE) tax, but other fees like origination fees and loan servicing fees might be subject to SE tax, as they're seen as part of active business income.

However, because you're operating through a partnership LLC, some accountants might interpret that income as ordinary income, which could be subject to SE tax. It's a bit of a gray area, so it's important to clarify how your activities are structured and reported.