Flipping as Active Income - Tax issue/Question

[Jonathan C.]

Hi All,

I have read a lot of posts & books and even attended "Guru" seminars that all seems to make the same statement that a Flipper pays his/her profit as active income - in tax bracket of 30%(?) vs. 15% capital gain tax if one holds the property 1year+. 

I have not spoken to any CPA but my question is, IF all the the flips are done in an entity - say an S-Corp, and if I use the profit from my flip to purchase the next properties, there really isn't any profit at the end of the year because all the money gets invested into acquiring the next property(ies) until the day I stop flipping, is that correct? Or should I say is that acceptable by the IRS? 

The business of the company is buying, fixing and selling real estate, and capital is used to conduct business (buying & fixing), I am just growing my business, not really enjoying any income (except for the "fair market salary" for the S-Corp owner). 

Example, 500k put into a flip project, sold for 700k, profit 200k. Then immediately use 500k+200k(profit) to purchase 2x 350k properties for next flip, then sell and buy another couple higher priced properties. And then keep rolling year after year. 

Of course even if re-investing is acceptable, there will be a BIG tax bill at the end of the road, so now comes the second question, is it possible that at the end of the flips the company purchase commercial/multi unit and hold on or keep doing 1031 exchange. So there is really no active/profit income all along the way, just building wealth/equity, anybody knows what does Uncle Sam says about this?

[Brandon Hall]

@Jonathan C.

For example, the company received $1MM from selling off their inventory but spent that same $1MM to purchase other properties, there really isn't any profit on the books for that particular financial year. No dividends to pay out either because there is no "profit materialized" if you view it from the business/accounting point of view for that financial year.

Do you mean we pay tax for every particular property when it is sold?

Answer: Yes. Flippers will treat their properties as inventory. At the point in time a business sells inventory, the corresponding accounting entry is "Cost of Goods Sold" which is a fancy way of recognizing the expenses associated with that inventory. Every transaction will have a profit, for instance if the selling price of inventory is $20 and the Cost of Goods Sold for that inventory is $15, the taxable profit is $5.

If we apply this concept to flipping houses, you will see that even if you turn right around and spend your profits, you will still have to recognize profits from the sale of your properties on your books. It doesn't matter how you re-apply your capital, if you flip a property and make a profit, that profit will be reported and is taxable.

2) I know 1031 Exc is not for flip properties. What I mean is that IF at some point in the future, there are no more flips, the company start to hold on to the properties and not selling off any of them, so when held longer than 1year, the capital gain tax then comes to play.

Answer: Properties are evaluated on a case-by-case basis by the original intent (strategy) of the property's acquisition. If you intended to flip a property, but hold it for ten years, profits will still be subject to ordinary income rates and SE tax. Of course there are ways around this, but the burden of proof is on you as the taxpayer. If your company has a long history of flipping, the IRS will assume all properties acquired have the intent of flipping. At that point, it doesn't matter how long your hold period is.

You can get around this by creating a separate entity that ONLY holds rentals. Your cash from your flipping entity can be funneled into the rental entity without triggering active income rules. However, this can be a complicated game and you really need to make sure you hash out a strategy with a real estate CPA - not a generalist.