Tax implications of renovating a long-term rental to sell??

Question

I am a small-time landlord with 6 SFH rentals, all of which were purchased to be rentals (retirement income - I spend an inordinate time worrying about retirement lately) and all have been rented since purchase.    I was reading Amanda Han's Book on Tax Strategies, and was surprised to read (on p. 104)  that "Fix-and-flip properties are not generally eligible for long-term capital gains tax rates, regardless of how long you own the property before selling it."

I've looked through the capital gains threads in this forum (thanks @J Scott, Brandon Hall and others), and am still not sure of the answer to my particular concern. I've sort of been thinking that I might do a big renovation in a few years on the property I've had longest (nearly 15 years) -- it's the smallest house with the lowest rent, in the most rapidly appreciating neighborhood -- and then sell it.  Or I might not.  Surely having considered a flip as a possible exit strategy doesn't negate the intent to buy-and-hold.  Or does it? (if so, I totally blame BP for the idea!)

My questions are:

1) Does a big fix for the retail market automatically put profits into the "ordinary income" flip category?

2) What if I've moved into in this house as my primary residence for 2 years (kids will both be in college) before the renovation and sale? Does that change things?

3) What if I do a big fix on my own personal residence (treat it like a luxury flip) prior to selling?  It's another long-term hold (20+ years) in a super hot neighborhood -- can I rent it for a year, renovate & sell and still be taxed as gains on a personal residence and not the ordinary income flip rate?

Steven Hamilton II · Answer

@Anna Watkins,1) No it does not. That is completely different when you've held the property as a rental. The issue pertains to properties that you acquire and then sell. If you are holding it for rent that is different.

2) Your residence is a primary choice to flip every 2 years or so.

3) You can do the same thing with your personal residence.

A renovation before sale is common. The issue is purchase and immediately trying to sell it.

John Woodrich · Answer

Given the circumstances I side with Steven on this, the intent of the 15 year rental property is clearly a rental.  I don't have the time to commit in studying the case law tonight but I can see how one would orchestrate an 11 year rental with the intent to flip.  Say you purchased below market price, rented it below market rent to a girlfriend, friends, etc, etc.

Anna - You also should consider the risk of holding the property if you are thinking of moving in. The gain exclusion would be nice but you may subject yourself to market risk. I personally would be surprised if rates don't start pushing up.  As interest rates increase, affordability and house prices go down.  Something I would be considering at least.  Don't let the tax treatment stop you from making the right decision for you.

Steven Hamilton II · Answer

Brandon,My point is facts and circumstances. A rental held for 15 years is a bit different. There has to be a number of re-allocations or typically transactions that involved flipping or common turnover in order to get to that point. But yes, I agree it can happen. I've seen 1031 exchanges turn over because taxpayers don't follow directions.

Brandon Hall · Answer

@Steven Hamilton II I wouldn't be so quick to jump to conclusions. In Allen v the U.S., the taxpayer owned one parcel of land for 11 years and upon sale the court ruled it was inventory and would be subject to ordinary income taxes rather than cap gains.

My point is, @Anna Watkins, that you need to speak with a savvy professional and lay out your facts/develop a defense plan before you redevelop. Intent can change and there is plenty of case law to support that. There is also plenty of case law to support long term gains. Just don't go into this unprepared.

Steven Hamilton II · Answer

Anna,The cases Brandon is referring to were often held just over a year or even two years. Or the Taxpayer was repeatedly buying holding for a year or two and selling. There was more made on the turnover of the property than there was on the rental aspect of the property.   It all comes down to intent that can be shown.

Steven Hamilton II · Answer

Brandon, That is true; however, in the situation of a property as a long term rental as she stated in her example I would not be concerned about it. The intent was quite clear.

Anna Watkins · Answer

Thanks @Brandon Hall and @Steven Hamilton II.  I'd be interested to read the cases you mentioned, Brandon (I'm a geek like that) -- and whether it pertains to primary residence as well as investment holdings.  As for the details, who knows what else I'll be doing if I ever get around to the fixing and/or selling?  It's only a "maybe someday" idea, but it's always good to know all the implications of various options ahead of time.

Brandon Hall · Answer

@Anna Watkins @Steven Hamilton II

There is case law out there to support a long-term hold being classified as a flip if it is substantially improved prior to re-sale.

I'd want to understand how much of your time will be dedicated to this reno, how much income it generate compared to all of your other sources of income, and how many other flips you have done or will do in the future.

If it's a one off reno, then you'll most likely be fine.

Tax implications of renovating a long-term rental to sell??

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