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Flipping taxes

lumbermonkey | Posted in Business on October 10, 2009 05:15am

Pun intended.

I met with my accountant yesterday regarding my next RE venture. My naive plan was to buy a dump in a good neighborhood, claim it as my primary residence, take two years to fix it up and then sell it for a modest tax-free profit. The problem is I already own a house in town and the IRS would want me to sell it or rent it or ? before I claimed a new primary residence.

Naive plan #2: I buy the dump, fix it up and hold it for a year so I get long term cap. gains treatment on the profit. Denied! The profit would be taxed at income rates PLUS 15% self employment. Meaning (in my personal sit.) more than 55% tax on the profit.

How’s a guy supposed to make half a buck?

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  1. Hiker | Oct 10, 2009 05:46pm | #1

    I am not so sure he is correct about the tax rate on plan #2.  A flip a year does not make that your business at least according to my accountant and therefore subject only to long term cap gains. 

    Don't call me when the IRS knocks.

     

    Bruce

    1. User avater
      lumbermonkey | Oct 10, 2009 05:55pm | #3

      I guess the issue is wether you're "investing" in RE vs. being in the "business" of fixing houses to sell. The accountant said I could try and go the "investing" route and pay only cap. gains but I'd somehow have to prove my intention was to "invest" in a property, not fix it up and sell it???

      1. Hiker | Oct 10, 2009 06:11pm | #4

        Can you demonstrate that you make money as a carpenter working for other people or better yet are you an employee of a construction company that you own and give yourself a paycheck.  That easily differentiates the two.  By the way, you can pay the construction company to do the repairs.

      2. alwaysoverbudget | Oct 10, 2009 07:33pm | #5

        it isn't hard to show it was a investment that didn't work.. while working on it,run a ad in craigslist every couple weeks"for rent" make the rent really high ,no phone they have to email you.after all your not interested in landlording.

        keep a copy of the ads. when your done with the house sell it.

        you tried to be a landlord, but it didn't work out?

         

        let me know your jail cell number so i can send you cookies.lol

        for me i would fix it,rent it to good tenants for a couple years  and get all my fix up money back,then sell it, do a 1031 exchange and do it again.thats the best tax loophole going.the older i get ,

        the more people tick me off

  2. renosteinke | Oct 10, 2009 05:54pm | #2

    You're on the right track.

    One of my customers has made a career of what we now call 'flipping' properties. He's been doing this since the early 70's - long before it was fashionable.

    He is a high-school dropout, but his grasp of real estate and tax law exceeds that of most CPA's and lawyers. Tax planning is a major element in his business plan. All these years with the same wife, seeing the kids through college - and I doubt he's ever lived in a house more than 4 years; even his some is part of 'the plan.'

  3. Piffin | Oct 10, 2009 07:42pm | #6

    EZ - pay Uncle Sam the other half

     

     

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  4. DanH | Oct 10, 2009 08:35pm | #7

    As I understand the law, to qualify for tax-free resale, a house must have been your "principle residence" for N out of the last M years (3 out of 5?). The law does not prohibit you from owning other properties (or doing whatever you want with them), so long as you satisfy the "principle residence" rule for the one you sell (which is to say that you actually have to live there most of the time).

    Not sure what the rules are on non-occupied flips.

    As I stood before the gates I realized that I never want to be as certain about anything as were the people who built this place. --Rabbi Sheila Peltz, on her visit to Auschwitz
  5. jimAKAblue | Oct 10, 2009 11:22pm | #8

    Where there's a will, theres a way.

    Find a local REIA chapter and find a good real estate cpa and lawyer.  You will be dabbling in the gray area of the tax law but if you contruct your business plan flow chart properly, you'll be able to accomplish what you are after. The IRS might still be able to categorize your deals as dealer property but that is the risk you always run when you are dabbling in this type of biz.

    1. User avater
      lumbermonkey | Oct 11, 2009 04:46pm | #11

      "It's a facts-and-circumstances test. There's no rule of thumb that says: Buy three houses, you'll get capital gains; buy five and you're a dealer-trader. The IRS looks at whether the activity is really a business."My accountant is a real stickler and she's warning me that the IRS is beginning to look at these deals very closely.
      I'm wondering when and where in the RE transaction are numbers reported to the IRS? Is it entirely a self report transaction?

      1. alwaysoverbudget | Oct 11, 2009 05:18pm | #12

        when you start talking about "how will they know" you are really asking for trouble.

        if you paid cash,sold fro cash, when you do a closing the title company informs irs of sale. you have money coming in and out of bank acct,etc.

        if it's something you want to do,then i would go to my "stickler accountant" and tell em to put together the rulings on "investor/contractor"

         

        i just don't see a problem with a house or 2. you buy and flip 10 a year,it's a business.

        you are allowed to invest ,even though you are a carpenter. i have a friend that sells crop ins. he is in the know about whats happening in the fields. so he buys futures,probably makes  1/2 mil a year on the futures.very closely related to his business,but he's taxed as a investor.the older i get ,

        the more people tick me off

      2. Hiker | Oct 11, 2009 07:36pm | #13

        It is good that your accountant is a stickler, but in my opinion, part of there job is to understand the breadth of the gray area.  Frankly it is easy for accountant be a stickler, but you end up giving it all to the government and in this case that is not what you have to do.

      3. jimAKAblue | Oct 12, 2009 04:52am | #22

        Don't be victimized by a stickler of an accountant who has a secret aversion to playing in the gray area. Yes, it's easy to be a stickler and pay the tax but it's probably easier yet to get a job and let your boss pay your taxes every week too.

        1. robert | Oct 12, 2009 02:05pm | #25

          Don't be victimized by a stickler of an accountant who has a secret aversion to playing in the gray area. Yes, it's easy to be a stickler and pay the tax but it's probably easier yet to get a job and let your boss pay your taxes every week too.

           

          I would Caveat that with:

          Small trips to the grey area usually DO NOT get the IRS's attention. BUt if they do, there is seldom significant enough profit in them to pay the accountant, interest, fees and penalties.

          If I was going to venture into the grey again (notice I said "Again"?) it would have to be for profit large enough that if it did not go my way? There would be something left after all the professional help was paid out.

          By the way, it did go in my favor. But took three years to figure out and cost me about half of what I made.

  6. robert | Oct 11, 2009 05:39am | #9

    DANGER WILL ROBINSON, DANGER........

    depending on your personal situation, making your current home a "Rental" may have some tax  pitfalls too.

    It's time to find a CPA who specializes in this kind of thing and get all the details.

  7. mikeroop | Oct 11, 2009 04:17pm | #10

    usually the bigger risk you take the more money you make!

    you don't have much to worry about unless you get caught doing something wrong (they prob won't pay much attention to one house here and there )

    I say GO FOR IT!

  8. fingersandtoes | Oct 11, 2009 07:55pm | #14

    About ten years ago I built a spec house in a subdivision where many of the houses around me were being built by serial flippers who claimed them as principal residences. Several of them later go into protracted battles with the CRA (your IRS) and at least one lost everything. My sympathy was tempered by the fact that I had been forced to sell my house for a very small profit to compete with their tax free businesses.

    Each builder I talked to had a different understanding of the rules. One would say it's ok as long as all your mail goes there, another one every year, one every 8 months - all different because they never found out what the rules were, but all vehemently sure their interpretation was correct.  I contacted the CRA and was told that what mattered was for them to be able to establish in court that there was a pattern to the activity, so there were no hard rules around length of residency.

    I guess my take is that you should go into this with your eyes open. Find out what the rules are, and if you are relying on operating in a gray area be prepared to pay the taxes at a future date and don't be surprised when the IRS comes knocking.

  9. PedroTheMule | Oct 11, 2009 10:51pm | #15

    Hi lumbermonkey,

    When working with your accountant and the IRS......110% of this comes down to "intent". That's your gray area. You didn't mention how long you've been in your current home. So I'm going to take it that you've been there for 5+ years and there are even variables for less time than that but we'll stick with this for now.

    Ok, so your "intent" is to make a tax free profit. One way for this to work in the same town is you buy the dump with the intent to repair and minimize your current living expenses through sweat equity. As soon as you've purchased, you move into your new dump. Change your mailing address, of course you can use a po box if you wish, change address on your drivers license etc. Put your current house up for sale. No crime in that. If you turn down any offers, document in detail "why".

    You finish your dump and it shines but you've not been able to sell the old home. Because of location your new start has better marketability and sells quickly and you move back to the old house that is still for sell. Now buy another, etc. You can go through this procedure twice every 5 years.

    There are a truckload of other details but if your intent is to actually "live" through this process and not simply skirt the law, then what could occur can be perfectly legal. Simply determine a plan for the project that is straight forward, sincere and honest, complete with any documentation to cover questions and move ahead. It sounds to me though that your accountant is against this plan because your purpose is to avoid taxes rather than build sweat equity. Tisk tisk.....that's a no no......

     

     

    View Image  

    1. User avater
      lumbermonkey | Oct 11, 2009 11:35pm | #16

      Thanks! That is exactly the info I was looking for.

      1. brownbagg | Oct 11, 2009 11:43pm | #17

        why not just go into the deal knowing you going pay IRS 55%. it just part of business. Knowing 55% compare to five to ten is easierthink of it like workman comp. cost of business

        1. jimAKAblue | Oct 12, 2009 04:55am | #23

          " Knowing 55% compare to five to ten is easier"You seem to be insinuating that his plan is criminal. That is a wrong characterization. At this point, he was attempting to learn what the rules are regarding the difference between passive and earned income with regards to real estate. His proposed scenarios are a further attempt to learn the intricacies about real estate law. None of this is criminal and even if he did take some deductions that were subsequently denied, it still doesn't mean it's criminal.

    2. fingersandtoes | Oct 12, 2009 01:57am | #18

       "Simply determine a plan for the project that is straight forward, sincere and honest, complete with any documentation to cover questions and move ahead."

      You have lost me a bit here. You have outlined a plan which would appear to be to establish the "intent" to move into a house as your primary dwelling, but really you have no plan to do so. It may work as a strategy but how does mesh with being " straight forward, sincere and honest"?

      The second time you mention the "intent to 'live' through this process and not simply skirt the law". Here again I don't see how any intention changes the fact it appears to be a tax avoidance strategy. How does intention change that?

      1. PedroTheMule | Oct 12, 2009 03:31am | #19

        Hi fingersandtoes,

        Here again I don't see how any intention changes the fact it appears to be a tax avoidance strategy. How does intention change that?

        Ever tried to grasp how many laws there are on the books concerning tax liability. It's too many to comprehend. But in those laws are certain allowances. So much of the time there are laws that even appear to contradict other laws. That's where gray area develops. You are completely allowed to buy a house, fix it up and resell it without paying one penny of tax on the process provided it meets certain criteria which includes it as a primary residence and that it not go over certain allowable max gain which can include your spouse to double the allowable amount.

        If he can prove that is what his purpose is, then he and every other US citizen is allowed that under law. Just as you are allowed to deduct expenses such as mileage on your vehicle for business purposes. By law (again US law) you are allowed to take a set determined amount each year, some years change by the quarter, but you can take a depreciative and expense deduction "or" simply a mileage deduction....so let's say you choose the mileage deduction and choose to drive a worn out run down vehicle getting high mpg and you fortunately don't have to do any repairs...well you're actual cost per mile may only be 43 cents a mile but if you're taking the standard mileage, you may be deducting 58 cents a mile. Nothing illegal about it. No gray area, simply it's what the IRS has chosen to allow.

        I'm certainly no expert on this, simply, have learned some things are allowed by law and as such there is nothing illegal about following the law. In his case it sounds like his accountant has already determined his "intent" does not fit what is allowed, thus is advising against it.

        I am not in a position to determine his intent and that's why I shared the information with him in this way.

        If his purpose is to "pretend" to live there, then he's got a tough road ahead of him as he is not living within the law. Now if he sold his current home prior to this next purchase, he would have pretty substancial proof as to it being his primary residence but that is not a solid requirement.

        I hope I've answered your question here.....another way to look at this....You buy a home, live there for ten years and in that time you freshen up the paint, pull up the carpet and refinish oak flooring, etc and the area you're living in becomes a rather desirable market and you sell it for $400k more than you paid for it but in the mean time a similar home across town is still selling for 200k more than you paid for yours originally.....are you suggesting you'd be ok with paying 55% tax on somewhere between $400k total gain or even $200k difference even if the law allowed you to do otherwise?

        Again, his comes down to intent.....what is his purpose in going into this venture.

         View Image  

        1. fingersandtoes | Oct 12, 2009 03:55am | #20

          Wow, thanks for taking the time to write such a comprehensive reply!

          I guess my point is that the OP's question could without sugar-coating it be re-phrased "How do I get out of paying the taxes that all builders of speculative projects are expected to pay?" Now I'm not at all making a moral point - I think the tax system is skewed against the little guy and fair play to anyone who can reduce their taxes - but if you go into a project where you premise your profits being tax free based on a grey area, be prepared for the possible consequences when things don't turn out as you planned.

          1. brownbagg | Oct 12, 2009 04:17am | #21

            why not just ask the IRS

          2. PedroTheMule | Oct 12, 2009 05:41am | #24

            Hi fingersandtoes,

            without sugar-coating it be re-phrased "How do I get out of paying the taxes that all builders of speculative projects are expected to pay?"

            Give ya two more to contemplate......living like this he'll never make the 4.5 million a year that one of my client's makes developing multiple building sites and building multiple houses simultaneously by this method. This method will "potentially" net the OP a lovely tax free profit in the right circumstances but it's not the get fat and sassy rich thing it is imagined as. Although many builders, while they're busy making a living building for others will build their own house, live in it two years and sell it and take the gains tax free as opposed to paying full tax liability on the other houses they build and sell.

            And, you did good not making this a moral delima hahahhah....you've recognized more than you imagined fine grasshopper.

            Secondly.....let's really stretch the imagination......couple buys a house for 200k which is documented in courthouse records. Over the next 10 years they spend a rediculous 300k redecorating and adding no square footage. They enjoy the house for another 15 years untouched and the house degrades with rot etc. In the market for it's location and time it sells for 400k.....with the redecorating receipts gone 15+ years, it would appear that they made an equitable profit of 200k.....they're downsizing and moving into a very small retirement community......could they rightfully and capably pay taxes on 200k and still move into the 350k retirement place? No way....where would the justice be in that. Again a stretch but I know you can see where I was headed with that.

            Simply more fun to think about......and possibly capitalize on!

             

             View Image  

  10. WonderWoman | Oct 12, 2009 10:42pm | #26

    If you live in and own the house for a total of 2 out of the last 5 years the first 250,000 (500,000if married filing jointly) of gain is tax exempt. The 2 years owned does not have to be the same 2 years it was lived in. Move into the dump after its fixed up, put the other house you own up for sale. When the first house sells, buy another dump, fix it up over the course of the next 2 years, move into it and sell the second house.

    Downside to this is you have to move every 2 years and if you end up selling for a loss you can't deduct the loss , unless you make it a rental before you sell. If you don't have any other income subject to social security or self-employment tax you won't have earnings to collect social security on when you retire.

    1. DanH | Oct 13, 2009 01:31am | #27

      > If you don't have any other income subject to social security or self-employment tax you won't have earnings to collect social security on when you retire.Ah, but that's what SSI is for.
      As I stood before the gates I realized that I never want to be as certain about anything as were the people who built this place. --Rabbi Sheila Peltz, on her visit to Auschwitz

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