Avoid IRS Audit - Flipping vs. Investing

Most tax benefits are for investors and their investment property.  People who flip properties are not investors, according to the IRS.

The opposite of an investor is a dealer.

If you are a flipper, you are a dealer. Dealers do not invest in rea estate, they buy and sell inventory just like WalMart. The fact that the inventory is real estate is irrelevant.

Dealers are not entitled to the benefits of depreciation deductions, tax-deferred 1031 exchanges, or long term capital gains, to name a few concepts. In addition, a dealer who seller-finances must declare ALL profits in the year of the sale, not a pro rata amount depending on the payments received. Dealers taking tax deductions to which they are not entitled could result in audit, additional taxes, penalties and interest.

There are no clear rules about what is an investment property, and what is dealer property.

The IRS looks at factors such as holding period. Two years is usually considered safe, one year MIGHT be safe, depending on other factors. Those other factors include the owner's intentions, frequency of sale of other properties, amount of advertising for a sale, time and effort devoted to each sale, and whether the person has a day job or rental income to meet regular living expenses.  Investors don't actively and regularly try to sell their properties. Dealers do.

Most experts feel that a person can be both an "investor" and a "dealer," with each property classified as dealer or investment property. Other experts say that if you are classified as a dealer, all transactions will be tarnished with the dealer brush.  One solution is to keep your properties in separate LLCs. Identify each LLC as engaging in investment properties or flipping properties. Being a dealer has its own tax advantages not available to investors, such as the ability to deduct business expenses such as mileage and office expenses.  You just have to know how to play the game properly.