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May 9th, 2022
This week’s Tax School blog reviews how a taxpayer’s activity is viewed by the IRS when it comes to house flipping – purchasing a property, fixing it up, and selling it. The question becomes whether that rises to the level of a trade or business, or is it an investment activity? Intent of the person flipping the house and what are the facts and circumstances from the moment they acquire the property will be the basis of the discussion.
By Tom O’Saben, EA
Assistant Director, Professional Development & Outreach
U. of I. Tax School
LINKS FOR REFERENCE:
Hello again everybody, Tom O’Saben coming to you from the University of Illinois Tax School with the blog of the week. This week we’re going to talk about people who do house flipping. Is that going to be a business? Or is it an investment activity? Let’s talk about it. For those of you who don’t know me, my name is Tom O’Saben and I’m an enrolled agent, my information is provided to you here on the screen and you can look at that at your leisure.
So, we begin a discussion about the taxpayer’s activity, in particular we’re talking today about house flipping, the notion of someone who purchases a property with the intent of fixing it up and selling. The question becomes whether that rises to the level of a trade or business, or is it an investment activity? So, the first consideration we have to have in this discussion with our client is not going to be really the frequency of how many times they may or may not sell a property, but rather what is their intent? And what are the facts and circumstances from the moment they acquire the property? That’s going to be the basic place to begin.
And you know, we can have this conversation on a variety of fronts, for example, a taxpayer came to me during the tax season, this really wasn’t a house flipping question, but they said they’re going to buy a property in Florida. And I said, okay, what are you planning to do with it? They said, well, we’re going to treat it as a rental property because we’re going to need the income. But I can’t tell you that there isn’t someday that we might consider moving into that property as our primary residence. But we have no idea when that might be. So I could argue that the intent of that client in purchasing that property in Florida is in fact treated as an investment property. So, you can have the same conversation with someone who goes ahead and considers doing a property flip.
So if we’re going to talk about the individual who might be considered to be a dealer, because this is the language you’re going to find in the IRS publications, a dealer is going to be someone who is in the active conduct of a trade or business, or an investor, similar to this analogy I just gave you if the client purchases the property in Florida, and is going to treat it as an investment property. The issue really comes down to tax treatment, when you look at gain on sale, if you’ve got a dealer, that’s ordinary income. So they don’t have any capital gain treatment, they do not have the ability to do a lifetime exchange upon the sale of their goods and consider it almost to be like inventory. That’s what it is to the person who’s in the active conduct of a trade or business as a dealer in real estate.
Now, I don’t want you to get hung up on the notion, does that dealer have to be a licensed realtor? No, I think really what is the intent? Are we going to buy properties and flip them? Are we immediately looking for a profit? And are we in the business? Are we acting like a business? So that’s on the gain side. Now a dealer the interesting thing on the issue of if they would sell properties at a loss, there is no limitation on the amount of money that they can deduct immediately, if there is loss, if in fact, the client rises to the level of a dealer.
Now on the other hand, if they’re an investor, well, again, facts and circumstances and intent. I’m buying a property, I’m going to put some money in it, but I really don’t know what I’m going to do with it, maybe I’m going to convert it to a rental property, maybe I’m just going to see what happens over time. Well, there you’ve got capital gain treatment. And as I’ve got here on the slide, if they hold the property for more than a year and a day, then we have under current tax law, preferential capital gain treatment, which can be capped at a maximum of 20%. We don’t want to forget about the potential for 3.8% net investment income tax, we refer to that as NIIT, all of that is going to be dependent on the taxpayer’s overall income. But again, it goes back to the intent of the client and on the law side, if in fact the investor is not a dealer or an investor, then this is a capital asset. So, then we have a capital loss, which for most taxpayers, is going to be capped at $3,000 a year. And I find it interesting the number of times I’m asked that question about capital losses, let me tell you capital losses can offset all capital gains. But then what we’re talking about is after we’ve eliminated any capital gain for that year, how much loss can the taxpayer take? That’s where you have the $3,000 limitation and then carry forward of any unused capital losses. So all gains can be eliminated, it’s the capital losses that exist after capital gains are eliminated, which have a limitation. And if you have couples who are doing married filing separately, then that $3,000 limitation is in fact split in half or $1,500.
So, as I’ve already begun to say, to discuss whether or not we’ve got a dealer or an investor, we have to talk about the issues. What is the intent? And what activities has the seller done at the time the sale? Here’s an example, you have somebody come in and they purchase land. Okay, we asked them, what are you going to do with it? Alright and the taxpayer says, I’m going to turn it into a subdivision and I’m going to sell lots. What do you think you have there, more than likely we have a dealer? Yeah, you say, well, they’re looking to profit from that sale. But it certainly seems like they’ve perhaps established a business, perhaps talk about more facts and circumstances in a little bit. But they say no, I went ahead, and I purchased this land, I’m going to turn this into a subdivision, I’m going to sell lots, sounds to me, like we’ve got the potential here to be treated as inventory. But let’s say for example, we’ve got that client who comes in and we talk about the intent, what are the activities? What if the client purchases the property and just sits on it? And doesn’t do anything for a number of years? There’s no attempt to develop it. Could that be an activity of an investor? It might be, but it also still could be the activity of a dealer, couldn’t it? Just because someone purchases land, perhaps they saw it as a deal right now, but we must talk about maybe looking down the road. What is your long term plans for this land? If they don’t know, then I think we’re going to keep it as inventory and park it as a cost right now and carry forward. They may have some minor costs for maintenance to the land or real estate taxes, or maybe they carry some insurance. But I think the conservative thing to do is, let’s hold that and make the decision later once we could have more facts and circumstances surrounding this circumstance. And I again, I don’t want to say we’ve got a definitive answer. That’s the statement here is, could this individual be an investor? We also need to look at the history of what they’ve been doing. Have they done this kind of activity before? And are they just acquiring this land and the normal conduct of a trade or business, and they intend on doing something with it in the future. As opposed to, oh, a friend contacts me and says, hey, there’s this land out here in the country, that boy, it’s really a deal, you might want to look into it, and I decide to purchase it. And I’ve never done any development before. I really don’t know what I’m going to do with it. So, I just hang on to it in the meantime. Am I a dealer? Or am I an investor? I think it remains to be seen.
So when we talk about someone who’s an investor and they are dealing with capital assets, leave it to the Internal Revenue Code to not tell us what a capital asset is, in fact, code section 1221 tells us what isn’t a capital asset. And if you look at 1221 (a)(1), it says the assets that are held in the normal course of a trade or business are not capital assets. Well, thank you for telling us what a capital asset isn’t. But then that’s really what leads us down the road, which says, how are we going to determine whether this activity represents a trade or business? And therefore, a dealer, which means then that these assets they acquired are assets held in a trade or business, and therefore aren’t capital assets, and therefore have to be treated as ordinary income, or ordinary loss when they are sold.
Now, there are some court cases out there and they’re going to look very similar to some factors I’m going to talk about in a moment, but it really goes back to again, intent and activity. And this is not all inclusive and not one of these factors carries more weight than another. But let’s go through here, we get to intent, what was the purpose or intent for which the property was acquired? What is the purpose or intent for which the property was held? What kind of improvements were done by the taxpayer to the property? Well, sometimes you look at frequency number and continuity of sales. I’ll tell you right now, you’re not going to walk away from the session with a definitive answer as to how many transactions constitute investment activity, versus how many transactions constitute a dealer or trade or business activity. So what is the extent and substantial ability of transactions that occur? What’s the nature and extent of the taxpayer’s business, are they in fact in the business of selling properties or buying property and fixing them up and selling them? What kind of advertising do you see to promote the sales? Or is there no advertising? You know, trade or businesses, typically advertise, don’t they? They’re looking for people to come and buy their property. Not so with investors. What is the circumstance where are there properties listed for sale directly through real estate brokers, again, that goes to the notion or advertising or at least presenting the property for sale to customers, which certainly would seem to indicate we have a dealer versus an investor? Again, these are not all the factors that the courts might consider, but they are certainly some of them. And they go all the way back to those two statements that I made at the beginning, intent and activity.
And as I began to say, at the very outset of these court considerations, no one factor is considered definitive. And the courts might even look at what is the intent with each property sold, or court cases often, which I’m not citing right here. But nonetheless, you may have to consider the facts and circumstances of each property that the taxpayer sold and all of those other factors that go into play much like my analogy I gave earlier, where we had the discussion about the concept of holding property, but again, what is the intent? And if you know me at all, you know that I am a disciple of the nine factors. And the nine factors would come to play here, as well as they would in any other discussion within with a client about whether their activity rises to the level of a trade or business, or is an investment activity, or is in fact, potentially a hobby. So here, are those nine factors again. Are we acting like a business? Are their business records? Do we have a business checking account? Is it run like a business? How much time and effort are being put into making sales to others or attracting customers? Do our clients depend on this income for their livelihood?
You know, Warren Buffett makes a lot a lot of money on capital transactions. But I think we could see that he is an investor, when you look at the amount of time and effort put forward and the fact that he’s not selling his holdings, let’s say to customers, he’s trading them on an open market. Are business losses beyond the taxpayers control? Or is it typical for a startup type of business to lose money? You know, it’s sometimes the client will call you and I’ve had this experience, I know you have too, where they say I need to do something to lose money. And I tell people, well, that’s not going to be a business action, I can’t imagine that you would invest, for example, in the stock market and look to lose money. You know, you could make gifts to charities and help someone out and take a tax deduction there, but I don’t think you should approach any type of activity where you’re wanting to lose money. Are changes made to operations so that they can improve their profitability? Does the taxpayer have expertise in what they’re doing? Or do they seek the advice of others? What’s the history of success in similar businesses? Have they been successful before? Are there some profits in some years because their brother-in-law came along and said, hey, wait a minute, you can’t show too many years of losses, or the IRS will come along and say that activity is not engaged in for profit. Or does it make sense we’re just showing a little bit of profit? So we think and keep the IRS away? Or is it really the facts and circumstances of what happened? And what are the prospects for success? Are we investing in property, plant and equipment that may result in gain down the road? So again, you knew I would bring the nine factors into play here. But nonetheless, it comes into our circumstance of talking about house flipping, as well as it would in any other activity where the taxpayer is in fact making money. Are they an investor or are they in fact, a dealer, meaning that the activity rises to the level of a trade or business?
So, what are your key takeaways from this session today? When a client comes to us and they said, here’s what I’m doing, or maybe somebody has the good sense to come in and talk to you before they decide to purchase a property. You know, a lot of clients will get on the bandwagon after everybody else has and they think they can make money quick, as well as anyone else did. So they said, well, here’s what I’m thinking about doing. I’m thinking about buying this property I’ve seen in my neighborhood that’s been neglected. I think I can get it for a song and then put some money in it and turn around and sell it and have a profit. And I say, well, what is your intent? Are you going to do this once? Well, I don’t know. I’m going to see how this one goes and then we’ll take a look at how we proceed. Or the client might come along and say, you know what, I went to a course that talked about teaching you how to buy distressed properties and do flips. And I’m going to go after this, in fact, I’m thinking about quitting my main job, and this is what we’re going to do I intend on conducting this activity, you tell me what I need to do so that I can deduct every dime that I spend related to this business. Is it possible we’re going to see then continuity and regularity that the individuals are purchasing properties with the intent of buying more properties? Do we see continuity and regularity in the conduct of their business? You know, not every property is going to sell very quickly, I will tell you one client situation that in fact, yes, we have determined that it is a trade or business activity. But they have been putting money into a property over several years, what I have been doing is I’ve made them capitalize those expenses, and we’re holding it in the cost of that property until it ultimately is sold. So there are other activities that the client has during the year that are reported as trade or business, maybe they’ve done some remodeling work, or whatever it might be, that’s ordinary income. But when it comes to those expenses that they have for this property that I’m treating as inventory because I believe it relates to their trade or business, as a dealer, I really don’t think they’re an investor. I’m making him hold those expenses, segregate them and we’ll take those as cost in the property sold, when in fact, they do sell it. So, we have to have a conversation with our client, I think that’s important in any type of setting. We want to know what their intent, how much activity is involved. Is this a one and done type situation? Or is it a once in a while? Go back again to the factors. Are they acting like a business? You know, if they’re contracting with others, they’ve got a repair crew that goes out, you probably have a trade or business. If you’ve got somebody that, you know, I did a property several years ago, that worked out well. In fact, I have a client that does that. And in his lifetime or his lifetime and working with me, he’s probably done maybe four flips. I’ve treated every one of those as capital transactions. I did not believe that it rose to the level of a trade or business. Yes, there was a profit intent. But the activity was such that I didn’t see continuity and regularity. He had a normal full-time job, he would work on the property, maybe in the evenings, or on the weekend. And in one situation, he put a lot of money into a property over several years and you know what he did? He turned it into a rental property. Well, that’s being reported on Schedule E, all those costs that he did over the years, are sitting in the depreciable basis of that property. So you want to look at the intent, the activity, and does it have in fact, continuity and regularity. I know this doesn’t give you a definitive answer as to what to do with those house flips. But I hope it at least gives you a set of questions to ask when that client comes to you, their most trusted professional, and says what do you think? What am I going to owe on taxes when I get involved in this activity? You certainly then have at least a set of questions to ask and begin that conversation with the client to determine what type of activity we have. Are we a dealer, meaning trade or business, or are we an investor, where this is going to be a capital type transaction? So when it comes down to profit, again, if we’ve got to dealer then we’re also probably talking about the notion of self-employment tax, versus that investor, which worst case scenario is the property is sold after it had not been held for a year and a day, and we’re talking about ordinary income tax, but if it rises to the level of the investor, we’re not talking about the act of conduct trade or business and therefore no self-employment tax.
So, food for thought as you leave tax season now and begin your role as a planner for your clients looking forward into the future to minimize their tax consequence and maximize their profitability. So, for all of us here at the University of Illinois Tax School, this is Tom O’Saben saying famously the quote from Jack Buck, we’ll say goodbye, for just a while.
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