|Saturday, July 26, 2014|
|Friday, July 25, 2014|
|Wednesday, July 23, 2014|
|Tuesday, July 22, 2014|
The Truth about Taxes and Your Fix and Flip Business
During the past few months I have seen quite a few blogs, posts, and comments about how taxes are assessed on fix and flip properties. There seems to be a lot of confusion and conflicting information so I wanted to use my blog this week to focus on some of the basics of how fix and flip properties are treated for tax purposes.
To start off, it is important to note what exactly a fix and flip property is. If you are an investor who is in the business of purchasing properties, rehabbing them and then selling it quickly for a profit, then this may fall under the fix and flip definition. With a flipper, the intent of the investor is to buy, improve, and quickly sell a property or properties. In the eyes of the IRS, this is treated as an active business and has the same tax treatment as if you were in the business of buying and selling cars for a living.
The downside of flipping for tax purposes is that higher taxes are frequently associated with flipping income as compared to rental income. Here are a few of the major downsides tax-wise of flipping:
1. No Capital Gains Treatment
If a flipping transaction is considered active income, there is no long term capital gains tax treatment, even if you have owned the property longer than a year from the purchase date to the sale date.
2. No 1031 Exchange
When we own rentals, one of the greatest tax deferral techniques that we often use is the 1031 exchange. The 1031 exchange allows us to sell a property for a gain and defer the associated taxes, provided that we roll the funds into another investment property. However, since flipping is not considered an investment activity to begin with, there is no 1031 exchange that can be used with respect to flipping activities, even if all the proceeds were re-invested back into another flip.
3. Payroll or Self-Employment Taxes
If a flipping transaction is treated as an active income, it means that the person actively involved in the deal may also be subject to payroll or self-employment taxes. This is accrued by flippers the same way it is accrued by those who work a W-2 for a living or maybe a realtor who makes commissions income via a 1099. Fortunately, with the correct legal entity structures, a significant portion of the payroll/self-employment tax may be avoided.
What Can Be Done?
As you can see, there are quite a few tax pitfalls when a transaction is considered a flip. From a strategic planning perspective, it is important to clearly understand what defines a flip transaction and what can be done to avoid this designation.
Luckily for investors, the IRS does not have a strict set of guidelines to define what constitutes a flip transaction. For example, there is no court case that says “if you flip 3 or more properties then you are deemed to be a flipper and if you flip less than 3 properties you are ok”. In fact, the Tax Courts make their determination on a property by property basis.
This means that one taxpayer can be deemed to be a flipper with respect to one property and not a flipper on other properties that he sells during the year. In fact, one taxpayer sold several properties in a particular year and of the handful that he sold, only 2 of them were deemed to be “flips” and the rest were allowed as investment properties eligible for the capital gains treatment.
If you are wondering how this could happen, the answer is simply that the determination of each transaction is based on its own set of facts and circumstances. One property may have a very different set of facts and circumstances from the next and in these cases, even if the investor is the same person, those two transactions can have very different tax treatments.
One of the most powerful facts that can work in your favor if you are looking to avoid the flipper designation is the word intent. What your intentions are with respect to a transaction can have a significant impact in terms of how much you pay in taxes.
For example, I had a client who purchased a property, rehabbed it, and sold it all within a 4 month period. On the face of it, this looks to be a flip transaction right? Well, not so fast. For this particular taxpayer, his intent going into the property was actually to rehab it and hold it out as a long term rental.
In fact, even before the property was fully rehabbed, he already listed it for rent and people started to come by to view the property before it was ready. As luck would have it, one of the people who came to preview the property made an offer to purchase the property. Even though it was the taxpayer’s intent to keep it as a long term rental, this unanticipated offer to purchase it was too good to pass up and he decided to sell it right after the rehab was complete.
In this scenario, even though it was purchased, rehabbed, and sold in just a few short months, his intent with respect to this transaction was that of an investment and not of a flip and as such, he was able to get all the preferential tax treatments as an investment transaction. Since he ultimately decided to reinvest the proceeds back into another long term rental, he was able to use 1031 exchange to roll all the profit into the replacement rental property he later purchased and therefore paid zero tax the year this first unit was sold.
As with most things in taxes, the law can often be complex. Sometimes the complexities work to your advantage and other times it takes a little more digging into.
Do you have any stories where you had a big win with taxes?
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Why You Don’t Put “Lipstick on a Pig” in Real Estate!
Time and time again, I’ve come across many real estate investors and companies that like to cut costs on hidden repairs, especially when they are buying older properties.
Although a cheap and temporary fix might look attractive at first glance, it will definitely result in costing you more in the long run, regardless if the property is a buy-and-hold or a buy & flip.
Below you will find a couple of tips that I have learnt while renovating properties over the years. These tips can assist you with doing the right thing and having a performing cashflow investment.
When renovating properties in lower income areas, it is crucial to insulate the roof and walls.
In the cold winter months the insulation assists with containing the warm air, and during summer the insulation will prevent the suns heat from penetrating through the property while at the same time allowing the cool AC air to stay within.
This will significantly lower the tenant’s monthly gas and electric bill. Most tenants in lower socioeconomic areas are hard pressed for funds and should not be given any reasons or excuses to short the monthly rent and pay for other unnecessary expenses.
Another “hidden” item that causes landlord grief and tenant disturbance is neglecting the plumbing.
Some of the main problems that can occur are: Backed up house trap, bursting copper pipes, and clogged drains. I highly recommend that every real estate investor contracts a competent and trustworthy plumber, who has years of experience working on properties and in the areas of interest.
With his experience he should be able to predict all future maintenance issues and address them upfront during the renovation process.
Implementing these simple tips, the estimated or promised numbers on paper will be more achievable when evaluating the deal.
There are too many shady operators that offer “amazing” numbers for PIG properties with only the very basic cosmetic work being completed (i.e. paint and carpet). By cutting corners you will only smudge the prospect buyers and tenants eyes in paying top dollar when purchasing or renting.
This will in return make it a loose/loose situation. My experience has taught me that within 3-6 months of ownership issues begin arising and they become a never-ending cycle of problems.
These problems if not fixed in a timely manner, could result in that particular property becoming vacant and vandalized. Its unfortunate to see these homes becoming revolving doors with new investors coming and repeating the same mistakes over and over again.
By NOT putting “Lipstick on a Pig”, the buy-and-hold investor will save time and money without experiencing grief, the tenant will get a clean, renovated and efficient home and the flip investor will gain a good reputation and most likely repeat business for a very long time.
“It takes a lifetime to build a reputation, and only 5 minutes to loose one”
Thanks for reading
– Oink, Oink.
Do you have any crazy “lipstick on a pig” stories?
Be sure to leave your comments below!
|Saturday, July 19, 2014|
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