Real Estate Flipper, Capital Gains...

[FTS13]

I have a client who has his w2 job and has two rental properties, last year he bought a house, cleaned and painted it and turned around and sold it for a profit. He did well on his first flip, so he bought 2 other houses in 2012, incurred expenses by fixing them up and now both houses are under contract to close this year 2013. This is my first client with capital gains... I know I have to use Schedule D, and form 8949. But how are the 2 houses he bought in 2012 that will close in 2013 handled?

Thank you in advance!!

[Lion EA]

He's in the business of selling houses. The houses are inventory.

[FTS13]

Would I have to do it in Schedule C then? By doing this, he would be subject to Medicare and Social Security taxes? Am I wrong to just say that he should report these on Schedule D? By doing it this way, even though he bought them and rehabbed them in 2012, they sold in 2013 so he would recognize the gain in 2013. Thank you again for your help.

[jasdlm]

Would I have to do it in Schedule C then? By doing this, he would be subject to Medicare and Social Security taxes? Am I wrong to just say that he should report these on Schedule D? By doing it this way, even though he bought them and rehabbed them in 2012, they sold in 2013 so he would recognize the gain in 2013. Thank you again for your help.

Yes - FICA and Medicare .

[kcjenkins]

Yes, the first house was an 'investment' and he was not then 'in the business of flipping houses'. so you could properly put that on the D.

But things changed when he decided to expand into flipping as a business. Has to go on the C, the houses are Inventory until sold, and it's going to be SE income.

[Guest Taxed]

Facts of this situation correctly point in the direction of a Sch C because in a span of 2 years he is selling 3 houses. I have a few flippers as clients and they do it once every few years and none lately.

On a Sch c as you know he can deduct his other expenses of operating the business so there may be a possibility of lowering the profit margin.

[BulldogTom]

Easy on that "has to be on a schedule C" talk. Go back and look at all the factors that make up a business. We usually look at them for the purpose of convincing the IRS that it is not a hobby, but we can use those rules and court cases to prove our clients "are not in business" as well. Here are my questions?

Does he have a profit motive?

Does he keep books and records like a business would?

Does he get significant personal enjoyment out of the activity?

Does he have a history of success in this or a similar busines activity?

What percentage of his income does he derive from this activity as compared to his full time job?

Does he advertise?

Does he seek advice from other professionals on how to increase his revenue/profits?

If your client is doing this for the fun of it and is not really concerned if he makes a ton of profit or a little profit or even loses a little, he is not in business.

Just my 2 cents. I am suprised Jainen did not write this post.

Tom

Hollister, CA

[Pacun]

If flipping house is always profitable, it doesn't make any different if you are running a business or a hobby. Sch C is the way to go.

[BulldogTom]

If flipping house is always profitable, it doesn't make any different if you are running a business or a hobby. Sch C is the way to go.

Why? To pay the SE tax? Why would it make sense to expose your client to a tax that may not be appropriate?

Tom

Hollister, CA

[Ranger]

Easy on that "has to be on a schedule C" talk. Go back and look at all the factors that make up a business. We usually look at them for the purpose of convincing the IRS that it is not a hobby, but we can use those rules and court cases to prove our clients "are not in business" as well. Here are my questions?

Does he have a profit motive?

Does he keep books and records like a business would?

Does he get significant personal enjoyment out of the activity?

Does he have a history of success in this or a similar busines activity?

What percentage of his income does he derive from this activity as compared to his full time job?

Does he advertise?

Does he seek advice from other professionals on how to increase his revenue/profits?

If your client is doing this for the fun of it and is not really concerned if he makes a ton of profit or a little profit or even loses a little, he is not in business.

Just my 2 cents. I am suprised Jainen did not write this post.

Tom

Hollister, CA

Those rules do not apply in this situation. They apply in determining whether a LOSS is allowed on Schedule C (or F) or limited to gross income. as misc deduction on Schedule A.

Otherwise known as the Hobby Loss rules, they are covered under section 183(a) of the tax code.

[jainen]

>>I am surprised Jainen did not write this post.<<

In other situations I have argued for Schedule C treatment when the taxpayer does substantial repairs or improvements. In that case the increase in value comes from the work being done, a classic business model.

In the original post, property was only cleaned and painted. Increase in value came from market forces, the definition of investment.

[Guest Taxed]

" Increase in value came from market forces, the definition of investment.". Is that not true for all antique dealers etc. I don't think they can get away without SE unless a corp?

[jainen]

>>Is that not true for all antique dealers<<

I don't think so. Personal property held for resale is inventory, not a capital asset. Real Estate can NEVER be inventory by definition, even when it is held for sale to customers.

[BulldogTom]

OK, just to cover this fully, assume that the sales fall through, the client puts the properties back on the market, and does not make any profits and wants to claim losses related to his "business". Losses that will offest his W2 income. But he also says he is done with this stupid flipping phase of his life. What do you tell him then?

What are the factors that will allow him to call himself a business and deduct the losses? The same ones I posted above.

My take is you have to be in business to have a business. What was the tax court case that said a grandma taking care of her grandchildren (for pay) was not a business. Same principal.

Tom

Hollister, CA

[Ranger]

In your example, the rules now apply because he has a loss. As others have pointed out, the rules of proving a profit motive don’t apply when you have a profit. The tax code is specific about that. It is not a science where for every force there is an equal and opposite force.

It is true that some of the rules overlap in determining if a hobby goes on line 21. Those are situations where recreation is involved: golf tournaments, bass fishing tournaments etc.

The fact that a business is otherwise enjoyable and the owner keeps sloppy records does not make it a hobby.

[BulldogTom]

Ranger,

If the rules were as cut and dry as you make them out to be, then the IRS would be able to assert that every loss is a hobby and every profit is a gain. It is not that cut and dry. Intention does play into it. You must be "in business" to be subject to the self employment tax rules. The code makes that very clear as well.

I won an appeal where the IRS asseted that line 21 treatment for occasional income reported on a 1099 was subject to SE. When I pointed out that he was not in the business of that activity, they issued a no change.

It may be that the OP client is in the business of flipping houses. But it is not a slam dunk and the facts and circumstances need to examined before that determination is made. The existence of profits does not automatically subject the profits to SE tax.

Tom

Hollister, CA

[Guest Taxed]

From an IRS perspective if a 1099Misc is received with box 7 more than $400, they are looking for a SE. If that is not in the return they flag it for a desk audit.

The flippers will most likely receive a 1099S after closing. Now comes the problem. If in a single tax year a bunch of 1099S are filed then the IRS will take the position that it is a business subject to SE. If only 1 is files I can see the point that it was an investment sale.

[Ranger]

Tom

It is not cut and dry, that was a misunderstanding. In the example you stated, the hobby loss rules would be applied to determine if the loss was allowed under section 183(a) of the tax code. Based on the information provided, I would say he was in business and the loss would be allowed considered the time and effort involved, the investment he made, and lack of personal pleasure or recreation generally associated with that activity.

There is also a misunderstanding that the hobby loss rules can be applied to determine if an activity is subject to SE tax. Section 183(a) has nothing to do with SE tax. The arguments that “it’s just for fun” and the client keeps poor records are invalid in respect to SE tax and you will not find them in the revenue rulings and court cases that deal with that issue.

That was the point I was trying to make.

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Regularity of activities, frequency of transactions, and the production of income are, accordingly, important elements in determining whether an activity will be considered a trade or business for self-employment (SE) tax purposes. ³¹

³¹
Rev Rul 77-356, 1977-2 CB 317; Rev Rul 58-112, 1958-1 CB 323;Rev Rul 55-431, 1955-2 CB 312 ; Rev Rul 55-385, 1955-1 CB 100; Rev Rul 55-258, 1955-1 CB 433;Hittleman, Richard L., (1990) TC Memo 1990-325, PH TCM ¶90325, 59 CCH TCM 1028, affd on other issue (1991, CA9) 945 F2d 409 ; Levinson, Melvin L., (1999) TC Memo 1999-212, RIA TC Memo ¶99212, 77 CCH TCM 2347.

[schirallicpa]

I would not consider this a business. No different than investing in a stock, making some money, and deciding to try again. Clearly investment in my mind. He's still at his day job. Buying 2 more houses isn't making him "in the business" at this point.

[mircpa]

I agree with schirallicpa. If client has 2 W2 jobs. This can be argued as investment property schedule D

[ari]

His intent counts to ascertain ordinary income vs cap gain

Also, the shortness of time he held the property counts in determining cap gain vs ord inc

Sounds like ord inc subj to se

[WITAXLADY]

I agree Sch D also but he needs to be made aware of the frequency and would be a Sch C if he continues at this rate.

[jlewis]

Interesting article from July, 2007 CPA Journal, particularly end of article. Somewhere else I read had an answer to the question if flipping was a business replied " I don't know and nobody else does either."

RE Flipper.pdf

[Gail in Virginia]

I agree that this an interesting article. Somedays I do wish the tax code was a little less open to interpretation. I want to obey the law but I also want my clients to have the benefit of the doubt, if any.