A historically important real estate question

Q: Six years ago my wife and I began buying, improving, and flipping homes. We both had full-time jobs and did the house flipping mostly on weekends and some weeknights. Initially this was one home at a time and it slowly started to grow. Four years ago we consulted a tax attorney to discuss how to report the sales. He told us that we could report all gains as capital gains, but we

had to be careful how much activity we had because it could start to look like a “regular” business. Well now I have quit my job and am doing the house flipping full time and my wife is working part-time from our home and also helping with the houses. Can we continue to report capital gains or should we go back to the attorney to see how we might change how we do things?

A: Your question is one of the oldest, and historically most important, facing real estate investors. That is, am I an investor, who can report capital gains, or am I a “dealer,” who must report ordinary income?

The law says that you should report ordinary business income for gains derived from the sale of property held primarily for sale to customers in the ordinary course of a trade or business. This law has created headaches for everyone who dares to touch it.

Taxpayers generally want to avoid meeting this business test. The IRS then wants to contend that you do meet the business threshold purpose. That much tends to be easy to discern.

The problem arises when either party tries to determine the “primary” purpose for holding property, whether there is a business and, if so, whether that business is selling property, then whether a particular sale is ordinary and whether it was made to a customer.

Taxpayers have played with these words and said, “wellllll, maybe I don’t meet all of the terms and conditions specified.” Courts task the IRS with contending that every “if and whether” in the above definition is met.

The courts have tried to focus the test to a few most important factors. These include (1) do you have frequent sales, (2) are these sales continuous over the years, (3) is the income from these sales substantial in relation to other income you may have, and (4) have you made substantial improvements to the property before sale?

As the number of sales increases, as the time period over which sales are made lengthens, and as you spend more time working on and selling houses, you look more and more like a “dealer.”

Are you a dealer? That’s very hard to say. You are either there or you are quickly arriving there. You can then do two things. First, stop looking like a dealer. That one sounds like it will be hard, as it almost always is for successful flippers.

Second, before changing a successful pattern of behavior, consider the cost of being a dealer. It once was very high. Now I am not convinced it is a huge distinction.

In days of yore, when I started working with this issue, ordinary business income was taxed as high as 50% and long-term capital gains at only 20%. So avoiding dealer status could lower a tax bill by 60% (50-20/50). I spent much time working this issue.

Now long-term capital gains may be taxed at 23.8% for high-income taxpayers. This includes a 3.8% investment income surtax. Business income, again for the high-income taxpayer, is capped at 37% but may also be eligible for a new 20% deduction that lowers the rate to 29.6% (80% of 37%).

The difference in rates may be 29.6% versus 23.8%. The investor lowers the tax burden by only 19.6% (29.6-23.8/29.6). Still a savings, but not as much as in days of yore. For you nitpickers I am avoiding the Medicare share of SE tax because I don’t want to go on for another 300 words.

The tax difference today may not be significant enough to mess around with a business model that seems to be working for you. But get a competent preparer and let them decide for how long you can continue reporting capital gains.