House flipping: business or investment?

Question

Hi there,

I have bought and sold 2 properties over the last 3 years. My tax agent just told me that I would have to pay 15.3% self-employment tax since it's considered a business. But 2 houses in 3 years can hardly be a business - it's an investment strategy and should never be taxed as a business. Where is the actual threshold? How many properties in what period of time are considered business?

Can someone please help me shed some light into this?

Thanks a lot in advance.

Regards,

Marc

Louis Alvarez · Answer

Marc, I'm not sure what a "tax agent" is or what type of qualifications they have, but it sounds like you need to find a CPA with some real estate experience. Unfortunately there is no bright line test in the tax code that says X number and you are an investor and Y number you have a business. The determination is based on your particular facts and circumstances and even then court cases in different areas have made what would seem to be differing conclusions with similar circumstances. To over generalize, if someone had a full time job during the week and rehabbed a couple of houses, I would argue that the would be investing. On the other hand if someone's only source of income was flipping the same two houses the facts would lean towards a business subject to the SE tax.

You need to sit down with a CPA and go over your specific facts. As helpful as many BP members want to be I see too many responses to tax and legal questions that are 75% correct and that can cost you in the long run.

You need to sit down with a CPA and go over your specific facts.  As helpful as many BP members want to be I see too many responses to tax and legal questions that are 75% correct and that can cost you in the long run.

Brent Coombs · Answer

@Marc Biedenkapp, according to this website, if you don't do it the way your tax agent suggested, you'll be even worse off!:- http://taxfoundation.org/blog/how-high-are-capital...

Which would you prefer: 15.3% or 25%? [Or did I miss something?]...

Account Closed · Answer

Marc Biedenkapp:

Louis Alvarez is correct.  That is exactly what any good Accountant will tell you.  Everything else here is a repeat of incorrect information rife on the forum.  You are not operating a business.  You are buying a capital asset and then selling it.  You don't have an inventory.  You don't have a second job.  You are not a Real Estate Professional (as the IRS defines that term).  Your intent when you bought the properties (if, indeed, you had a clear intent) is completely irrelevant (and also unprovable, by you or the IRS).  You will report the sales on Schedule D and pay Short Term Capital Gains tax or Long Term Capital Gains tax, depending on the time that you held the asset.  You are not subject to Self Employment tax.  Don't let anyone scare you.  Hold your ground.  You're fine.  You cannot unintentionally, unknowingly, or accidentally be a Real Estate Dealer with inventory for sale to the public.

Dave Toelkes · Answer

@Marc Biedenkapp,

You are getting a lot of misinformation in these responses.  It does not matter that you have a full time job.  You are allowed to have a second job; it could even be a home based business.

The question you have to answer for us is why you bought the properties.  It seems from your comments that the reason you bought a couple of properties over the past three years was to rehab and flip for profit.  If this is the case, then I agree with your "tax agent" that you are operating a business.  Your property is dealer realty, and the sale is deemed a dealer disposition. The IRS defines a dealer disposition as ANY sale of real property held primarily for sale to customers.  According to this definition, the "bright line test" that @Louis Alvarez refers to is "one" (IRC §453(l)).

I am guessing that you treated your sale profits as short term capital gains on your tax returns.  In your situation, the short term capital gains tax and the tax on your ordinary income are both the same rate.  You should have reported your sales on Schedule C (not Schedule D) and you should have paid the 15.3% self employment income tax on your sale profit IN ADDITION to the ordinary income tax you already paid.  Self-employment income taxes are the payroll taxes (FICA and Medicare taxes) that you and your employer pay with the withholdings from your paycheck.  When you operate a property flipping business, you are both the employer and the employee.

For future reference, your flip income is reported on Schedule C.  Jay Hinrichs misspoke -- rentals go on Schedule E, flips on Schedule C.

It appears that you will need to file amended tax returns quickly to stop the interest accrual on your back taxes.   Consult with a knowledgeable CPA to confirm that you "tax agent" is on the right track.

Bryan O. · Answer

Generally speaking, house flipping is not investing. You had a second job that you worked on the weekend. You can probably find a CPA that is willing to claim they were bought as investments, but flipping a house is as much investing as flipping a burger is: they both build money so that you can invest.

Brent Coombs · Answer

Wow. No wonder Texans love Texas!...

Marc Biedenkapp · Answer

Thanks for the answers guys!

@Louis Alvarez, indeed I did have a full-time job and only worked on the houses on weekends (I even held the second house for over a year until it was finished).

@Brent Coombs, good point but since there is no income tax in Texas, it should really be zero. I do pay tax on capital gains but not on income. I will look for another CPA who has more experience in REI and he'll hopefully sort that out.

Thanks.

Marc

Brent Coombs · Answer

@Marc Biedenkapp, won't the profits from your flips be treated at your top marginal tax rate otherwise? Might that be even higher than 15.3%? [Not tax advice, but ask around]...

Jay Hinrichs · Answer

@Marc Biedenkapp  from my limited expoeirnce when you buy them you need to set them up on your schedule C as rentals day one.. if you do that you get long term treatment.. if you intention is to buy and flip.. ordinary income

House flipping: business or investment?

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