Investor vs Dealer in the Real Estate World
How many of you love watching HGTV? A lot of you, I’m sure. It is the fourth most-watched cable network in the United States.
Shows like Flip or Flop, Zombie House Flipping, or our local favorite Fixer Upper are just a few popular real estate shows. They make it look easy by making anywhere from $50,000 to $100,000+ for one deal.
Currently, house flipping is at a 12-year high. Of course, if you could make such a profit on just one deal. However, the one thing these shows don’t tell the would-be flipper is there are significant tax implications when you get into flipping houses.
Most importantly, the tax rules that classify you as a “dealer” vs. an “investor”.
Think of your local clothing boutique. All the clothing and accessories are in inventory, and once sold, that item comes out of inventory as a Cost of Goods Sold and you pay income tax on your profit.
Depending on how the boutique structured their business, that profit may also be subject to self-employment tax.
That is exactly how you treat a flipper.
The house they purchased is not considered a capital asset but as inventory. Thus, when the flipper sells the home, they do not pay capital gains on the sale, but rather ordinary income and possibly self-employment tax. All activity for this sale will be recorded on Schedule C,NOT Schedule D.
There is no automatic tax deduction for expenses and costs for house flipping for dealers because they need to capitalize on all direct materials, direct labor, and indirect costs to each job or house. Indirect costs include interest expense, real estate taxes, utilities, rent, depreciation of equipment, insurance, and indirect labor. These costs are not recognized until the property sells.
A taxpayer who purchases a house for its future, appreciated value, treats this house as an investment property. One of the biggest benefits is if you hold this property for one year, the sale is taxed at capital gains rates vs ordinary income rates. Investors can deduct all those indirect costs mentioned above in the year it was paid.
Since there are significant tax benefits from being an investor rather than a dealer, you want to make sure that your client is accurately classified. The following are a few facts to consider:
- What is the purpose of the property purchased? To become a rental property or for a quick sale?
- The extent of improvements and advertising to increase sales. Did your client immediately put feelers out that they have a property that will be on the market soon?
- Number, frequency, and substantiality of sales. How many homes did your client rehab and sell in a year? How many are they currently working on?
- Duration of ownership.
- Continuity of activity related to sales over a period.
- Extent and nature of the efforts to sell the property.
- The extent of subdividing and development to increase sales.
- Use of a business office for the sale of the property
- Character and degree of supervision or control over representatives selling the property (Ralph S. Norris, TC Memo 1986-151.)
For example, the taxpayer that wanted to get their feet wet in flipping and flips a single home would likely be considered a dealer rather than an investor. Flipping only one home would usually favor the investor treatment, however, their intent was to flip the house.
Richard A. Pettit, Petitioner v. Commissioner of Internal Revenue, Respondent is a good example of the above. Richard was a full-time American Airlines pilot who built one house as a side hustle.
The court ruled in favor of the IRS because Richard’s intent was to form a business and make improvements for an increased price.
If you are a real estate investor, flipper, or wholesaler of syndicated deals, it is imperative to know the tax treatment of each. The tax implications can be heavy if the wrong classification is used.