How to report profits from a flip with a partner

Question

First off, I apologize if this has been discussed in another thread but I couldn't find anything that addresses my particular situation.

I am seeking advice about how to report the profits from a flip with a partner.  I partnered with an individual on a flip with a 50/50 profit split.  He is the sole legal owner of the home.  I put up some of the purchase capital in the form of a loan to him (but NOT secured by the home).  We have split the cost of the rehab.  I am the listing agent on the sale side of the transaction.

I realize there would have been a better way to structure all of this but we needed to act fast to secure the deal and we both trust one another so we just did it this way to get the deal done.

My question is how each of us will report profits for the deal on our tax return when it is said and done.

A secondary question is if there might be a way to simplify the split by adjusting the listing agent commission on the back end.  I earn 100% commission and just pay a flat transaction fee to my broker.  So for example could my partner and I just modify the listing agreement I have with him before the closing so that I get paid my share of profits in the form of commission?  My initial thought is that this would have a negative tax implication on me in the form of it being 1099 income.  I do have a W-2 job which is my primary occupation so my understanding is that I can still avoid self-employment tax on profit from the occasional flip?  But will I be forced to pay it on 1099 income from being a R.E. agent?

If we don't do it this way, how will I report my profits?  Essentially after the sale he would be writing me a check for the money I loaned for purchase plus my share of the profits.  How will I report the profits on my return?

Bill Walston · Answer

So, a few observations...

First, you say that you LOANED some of the purchase price.. Are you going to get your loan paid back prior to profit split?  Or are you going to ignore the loan and just get 50% of the deal?

Are you going to forgo the commissions or are you taking commission and THEN 50% of the profit?

Did you spell all this out prior to your deal?  Do you have any type of written agreement?

In theory, you should file a partnership return with the appropriate Schedules K-1.  These amounts will be reported on your respective individual Forms 1040.

I don't suggest that you modify your listing agreement and take your 50% as commission. Your share of the profits is just that.  A 50% share of the profits - it's not a sales commission.

Finally, I'm not sure who gave you the idea that "profit from the occasional flip" is not subject to self-employment tax. That's just not correct.  Income from any property that you purchase to wholesale or rehab and sale is ordinary income and subject to self-employment tax. That said, the cap for income subject to the tax is around $117,000 - so if your W-2 income is in excess of that amount you will avoid self-employment tax on these profits for that reason.

I strongly suggest that you run this by your own tax pro.  He (or she) is in a position to know your particular tax situation and best advise you on the structure of the deal.

Tyler Smiarowski · Answer

@Brandon Hall

There are 9 standards that the IRS traditionaly has  used to determine if a taxpayer is a dealer or investor:

1. reason and purpose the property was acquired

2. lenght of time property held

3. number and frequency of sales, usually annually

4. continuity of sales over period of time

5. overall reluctance to sell property

6. substantiality of gain on sale

7. extent to which tp engaged in sales activities

8. substantiality of sales when compared to other sources of income

9. desire to liquidate

The taxpayer does not need to meet all 9 or any number. The IRS decides this on a property by property basis and not an individual by indivdual basis.

I do not know the details of Cooper's situation besides that he flipped a house. If a CPA, EA, or taxpayer wants to report a sale on schedule D..they most likely will be hanging their hat on  number 3,4,6, and 8 listed above.

Congrats on completing the CPA examination.

Brandon Hall · Answer

@Bill Walston is correct here. While in certain situations in may be appropriate to report a flip on Schedule D, that's not going to be the case here. According to the OP's stated facts, he entered into this transaction with the intention to flip the property and therefore dealer status has been achieved.

I just finished CPA testing (I'm a couple weeks away from being officially licensed) and I can tell you that if he were my client, there is no way I'd report his flip on Schedule D. What happens if he flips another property? Now I may be liable and the IRS may find me negligent in my services. I'm not going to take on that risk.

If he had said something like "I bought the property, wasn't really sure what I was going to do with it, then someone gave me a really sweet offer and I took it" then he could get by reporting the flip on Schedule D because the original intent was not blatantly to flip the property. But even then he will need to show a business plan and solid documentation.

@Tyler Smiarowski

Brandon Hall · Answer

@Cooper B. You said you have a deal with your partner to split the profits 50/50, therefore it can be said you have an interest in the property and you can likely still be classified as a dealer.

The methods you are describing may not hold up in an audit as they are not arms length transactions between related parties, so the entire transaction can be disallowed. It also sounds like you are venturing into a gray area of tax evasion, which is fraudulent.

You could avoid taxes by claiming your "investment" as a gift, and he can then gift you back your investment plus profits, however that ventures into a gray area as well. If you have an agreement (oral or written) the IRS could disallow the gift and slap you with a nice fine. Of course the IRS could also just say the gift was not actually a gift as well.

Honestly, transactions like these need to be analyzed by a CPA or lawyer. You need to give them all the documents and details and let them figure out how best to approach the situations.

Cooper B. · Answer

thanks everyone for the advice. Clearly there are different ways to interpret the rules here.

Not to muddy the waters even more, but technically I do not have an ownership interest in the property. My partner owns it 100%. If I didn't buy or sell the property then how can I be a dealer of it?

So when the property sells he can write me a check for my share of profits. Or, it can come out at closing as sales commission. What about the profit being paid as interest on the money that I loaned to him? (We didn't record the loan anywhere, and it would certainly be an exorbitant rate). Again, I realize there are better ways to do this, but this is the situation we are in now. Thanks everyone.

Brandon Hall · Answer

@Tyler Smiarowski Thanks, it was a tough few months of studying.

I think I'd narrow it down even further and say the most important factors in your list are 3 and 6. Case law cites that “the presence of frequent sales ordinarily belies the contention that property is being held for investment rather than for sale.”

To your point, the OP can likely report this one off flip on Schedule D as a case cites below:

Reese v. Comm’r [615 F.2d 226, 45 AFTR2d 80-1248 (CA-5, 1980)], “a single transaction ordinarily will not constitute a trade or business when the taxpayer enters into the transaction with no expectation of continuing in the field of endeavor.”

However, to my point, if he engages in flipping again, the IRS could hold this sale as part of his ordinary trade or business. I realize that it is a house-by-house basis, however if he has "prior and current dealings of similar property" then he could very well be classified as a dealer.

And again, it can come back to his primary reason for engaging in this real estate activity. As he stated, it was to flip the house, which can easily constitute dealer status unless he can show some sort of documentation stating that flipping was not the primary reason he engaged in the activity.

Malat v. Riddell, 383 US 569, 17 AFTR2d 604 (1966), The word “primarily” in this context means “of first importance,” or “principally”

And as I am sure you know: "IRC section 1221(a)(1), The term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include: property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business"

As defined by case law (C.P. Snell v. Comm’r, CA-5, 38-2 USTC para.9417, 97 F2d 891)., “business” means:

"The work, notwithstanding disguise in spelling and pronunciation, means busyness; it implies that one is kept more or less busy, that the activity is an occupation. It need not be one’s sole occupation, nor take all his time. It may be only seasonal, and not active the year round. It ordinarily is implied that one’s own attention and effort are involved, but the maxim qui facit per alium facit per se applies, and one may carry on a business through agents whom he supervises."

I am still under the contention that he is a dealer. Sure he can report on Schedule D, but why risk the pain especially if he wants to continue dabbling in flipping.

If he never wants to flip a house again, then Schedule D it is.

Not legal/tax advice.

Bill Walston · Answer

@Tyler Smiarowski, I think if you read my post that you reference you will see that it in no way contridicts what I've said in this thread.  It clearly states that IF you are a dealer by IRS deninition then you will be subject to self-employment tax.  IF you are NOT a dealer then you will report on Schedule D.  That's the same point I make here.  Income from flips ARE considered dealer income.  The fact that the OP states that he bought a property to "flip with a partner" is enough to establish intent to buy and sell for a profit .

I agree that the IRC isn't always black and white.  After nearly three decades in the tax biz I can confidently say that the system seems neither fair nor logical at times.  But it is what it is.

Tyler Smiarowski · Answer

@Bill Walston

I don't believe I am wrong on my assertion and my assertion is not "absurd". Just a few  years ago you had a different response to this, so I guess you "erroneously" gave incorrect info:

http://www.biggerpockets.com/forums/51/topics/58918-reporting-sale-of-flips-to-irs

Also I recently was at a CE and both well respected teachers (Hoven & Roberson) discussed briefly this topic and if your not deemed to be in the trade or business of flipping houses, etc...no self employment tax would be paid and the sale would be appropriate to be reported on schedule D (it was about a 10min discussion but that was the jist of it). Now if instead of just 1 house, it is multiple houses then that's something different and would more likely be deemed a trade or business and SE tax would come into play.

Obviously the IRC is not black and white and is left up to interpretation but to use certain terms like "absurd", "erroneously", etc is not the best way to have a discussion. I know quite a few CPA's who would find it appropriate to report this on Schedule D in this situation. I certainly wouldn't call them "absurd". If a CPA decides to report the sale on Schedule C I wouldn't call their position "absurd" either..just conservative.

Bill Walston · Answer

@TylerSmiarowski, you're just wrong on your assertion.  If your INTENT is to buy a property to wholesale to another investor or to rehab and sell to an investor or an owner occupant the income from the sale of that property is earned income taxed at both ordinary income rates AND subject to self-employment tax. Period. The number of deals is irrelevant.  The IRS has not established a "magic number" to determine when one becomes a "dealer" as opposed to an "investor."  One deal meets the requirement if the intent is to buy and sell for a profit (see S & H, Inc., v Commr., 78 T.C. 234).

An investor buys with the intent to hold for appreciation and/or rental income.As to your absurd attempt to compare wholesaling real estate to "dabbling" in the stock market my response would be that the teacher is not buying the stock to sell to another investor for a profit.  He's buying with the intent to hold with the hopes that the stock will increase in value (appreciate) and/or pay dividends.  That is, by definition, an investor.That said, if the taxpayer erroneously reported this sale on a Schedule D, you're right - he (or she) wouldn't trigger the self-employment tax.  Would it get caught by the Service?  Probably not. Does that make it right?  Not at all.I do agree that the OP should talk to his CPA.  I think you'll see that I suggested that in both of my prior responses to him.

Tyler Smiarowski · Answer

For the people that say even if you have a full time job and do just 1 flip...that the income derived from the flip is automatically subject to SE tax of 15.3%. My question to them is:

Is the person who is a full time teacher and dabbles in stock trades during the year...are their profits from the stock sales subject to SE tax? No, because it is reported on Schedule D. If they did it full time as their main source of income...then that's a different story.

Also just because income is considered "ordinary income" does not mean it is subject to SE tax. It just means it is income that does not qualify as ST or LT income (less than 1 year).

@Cooper B.

I would speak to your CPA. If you work a full time job outside of real estate..this one flip you did most likely will be reported on Sch D and not subject to SE tax. You will be taxed on your marginal tax rate...whatever that may be.

How to report profits from a flip with a partner

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