Since the housing market downturn, the national pastime of “property flipping” has fallen in popularity – heck, I haven’t seen a TV show on property flipping in ages. But the activity of buying a fixer-upper, applying a little sweat equity, and then reselling for a profit has been going on ever since Gog first rehabbed and sold that condo-cave with a view.
If you (or someone you know) are involved in flipping, there was a recent tax case that you may want to pay particular attention to. In this particular case, the question of how the sales receipts are classified was addressed, and how the Tax Court responded should be of interest to anyone involved in flipping.
Here’s how it played out: the taxpayer asserted (among other things), that the activity of buying, rehabbing, and then reselling the properties was an investment activity, and so any gains should be treated as capital gains. The IRS disagreed that this was investment activity, but rather a purchase and re-sell of inventory, and that the income from the activity should be treated as ordinary income.
The Tax Court agreed with the IRS. The nature of the taxpayer’s buying and reselling activity, given that they bought and sold between four and eight properties per year, holding them for two to three months in most cases. According to the Tax Court Memo, the following factors are used to determine whether an asset is a capital investment or if it is an item purchased with the sole intent to resell:
- The taxpayer’s purpose in acquiring the property
- The purpose for which the property was subsequently held
- The taxpayer’s everyday business and the relationship of the income from the property to the total income
- The frequency, continuity, and substantiality of sales of property
- The extent of developing and improving the property to increase the sales revenue
- The extent to which the taxpayer used advertising, promotion or other activities to increase sales
- The use of a business office for the sale of property
- The character and degree of supervision or control the taxpayer exercised over any representative selling the property
- The time and effort the taxpayer habitually devoted to the sales
For the full text of TC Memo 2010-261, click the link. But only do this if you’re a tax- or law-nerd, or if you’re having trouble sleeping. Do not operate heavy machinery while reading this document. You’ve been warned.
Apparently the factor in the above list that caused the greatest damage to the taxpayer’s assertion of investment activity is #4, frequency of sales. In addition, the absence of any intent to lease the properties to generate returns underscores the case that the property was purchased solely to re-sell.
Since the taxpayer purchased and sold fifteen properties within three years and did not attempt to lease or hold the properties for a significant period of time, the Tax Court deemed that the taxpayer’s business activity would be most appropriately classified as “dealers of real estate”. With that classification, the profits derived from sales (above the purchase price and rehab expenses) would be deemed to be ordinary income, subject to self-employment tax and ordinary income tax.
Other factors weighed on this decision, not the least of which was the fact that the profits from sales of properties constituted the primary source of income for the taxpayer during the period.
Understandably, given the much lower tax rate on capital gains versus ordinary income tax rates (not to mention the self-employment tax incurred), it would have been far better for the taxpayer if the profits had been considered capital gains.
As I understand it, in order to be truly successful at property flipping, volume is important. Turning over properties quickly at a profit while putting as little money at risk for as short a period of time possible is the name of the game. This can hardly be described as capital gains oriented activity – at least that’s what the Tax Court says.