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With mortgage rates at an all-time low, many people are exploring and undertaking the task of buying houses, renovating, making improvements, and selling them for hopefully more than their cost. This could be a profitable endeavor, however, there are tax consequences that should be factored in so you can generate expected returns.
The tax treatment varies based on how you are categorized by the IRS. You can be considered a dealer, investor, or homeowner, all summarized below. In some instances, it is clear cut what you would be treated as, and in some other cases, you would need to discuss with a tax professional.
Dealer in Real Estate
This category is akin to running a business, but without a separate corporate return. The gains are taxed at ordinary taxpayer rates. Since it is considered a business, the taxpayer would be subject to self-employment taxes of 15.3% of the net profit. For high income taxpayers, an additional 0.9% Medicare surcharge would be assessed on the net profit. In general, a dealer would pay more in taxes than an investor would. The upside is that any losses from real estate transactions are considered ordinary and would be fully deductible in the year the loss originates.
Gains on the home sale are subject to capital gains treatment. If the property is held for more than a year, then the long-term rates would be a maximum of 20% of the gain. If the property is sold within the year, then it would be subject to short-term rates, which would be equivalent to the ordinary tax rate of the taxpayer. For high income taxpayers, there is also an additional 3.8% surtax on the net investment gain. The benefit of being considered an investor is no self-employment tax nor Medicare surcharge is assessed. However, if for any instance you sell the property at a loss, the loss is netted against any other capital gains. If the losses are greater than capital gains in any given year, then the loss is capped at $3,000 with the remainder carried forward and utilized in the following year(s).
There are some benefits if you are considered a homeowner. If you were to live in the property while it is being fixed up and consider it a primary residence, and if you meet the following criteria, you could exclude the gain (up to $250,000 for individuals and $500,000 for married filing jointly) from your income.
Please be aware that if you incur a loss, then none of it will be deductible. In addition, some fix-up costs might be considered repairs instead of improvements, and as a residence, not deductible or contributing to the increase of the cost of your home. Finally, the two-year rules make it difficult to be continuously flipped and getting the homeowner exclusion.
Being a homeowner is easily identifiable, but the classification between investor and dealer might be harder to identify. The distinction between a dealer and an investor is based on the facts and circumstances of each case. The IRS and Tax Court have taken the following into consideration in determining if the taxpayer is a dealer or an investor:
Note that there is a provision in the current tax code for like-kind exchanges (known as Section 1031 transaction), which allows the taxpayer to defer taxes if they purchase another similar property in a defined time frame. This is a complicated transaction, which only applies to investors or dealers in real estate, and would need to be structured correctly to provide Section 1031 benefits.
Cray Kaiser is here to help if you have further questions about your real estate activities. Please contact us today at 630-953-4900.