Television and other media present a wonderful image about the opportunities for buying houses on the cheap and then quickly selling them for a profit in a rising market, often after renovating them to improve the value. What often goes undiscussed are the tax consequences from this activity of flipping houses. This includes the exclusion of gains up to $250,000 ($500,000 if married, filing jointly) from the sale of a principal residence or the incursion of capital gains tax on the sale of an investment property or of ordinary income tax and self-employment tax from a house-selling business.
SALE OF A PRINCIPAL RESIDENCE
Per Internal Revenue Code (IRC) §121, a taxpayer can exclude up to $250,000 ($500,000 if married, filing jointly) of the gains from the sale of his or her principal residence if certain requirements are satisfied:
- The home has been the taxpayer’s principal residence for at least two out of the past five years;
- The taxpayer satisfies the look-back rule, which means the two-year residency period doesn’t overlap with the two-year residency period of a former principal residence;
- The taxpayer didn’t acquire the home through a like-kind exchange during the past five years (IRC §1031);
- The taxpayer isn’t subject to expatriate tax; and
- The taxpayer satisfied other qualifying requirements, such as not being separated or divorced from his or her spouse during the ownership period and other eligibility tests found in IRS Publication 523.
This allows a taxpayer to buy, renovate, and then sell his or her principal residence every two years and, more importantly, exclude up to $250,000 ($500,000 if married, filing jointly) of the gains from the sale of the principal residence. Better yet, a taxpayer can do this process repeatedly as long as the requirements are satisfied each time.
It’s critical, however, that the individual keeps enough documentation to support the claim. For example, a taxpayer can only have one main home at a time. If the taxpayer owns or lives in more than one home, then a facts-and-circumstances test will apply. The most important factor is where the individual spent the most time, but there are other factors that the IRS may look at to determine the principal residence. These include the address the person uses to receive mail as well as his or her voter registration, federal and state income tax returns, and driver’s license and vehicle registration. Moreover, it isn’t just the address where the taxpayer resided, but also where the person works, where he or she banks, where family members reside, and the places the taxpayer regularly goes to for entertainment, community activities, and clubs to socialize. If the renovations are significant, it’s also important to demonstrate the residence is habitable during the renovations. Otherwise, it’s questionable whether the residence is truly the principal residence.
If the taxpayer fails to satisfy the principal residence exclusion rules, the entire gain from the sale is subject to capital gains tax. Assuming the house has been held for more than one year, the good news is that the gain is treated as long-term capital gains and taxed at preferential rates of 0%, 15%, or 20%, depending on the taxpayer’s tax bracket. That is, a person in the 10% or 12% tax bracket generally enjoys the 0% capital gains tax rate. Likewise, a person in the 37% tax bracket generally is subject to the 20% capital gains tax rate.
Because of the Tax Cuts and Jobs Act (TCJA), the crossover points for the capital gains tax rates aren’t exact. For example, a person at the upper edge of the 12% bracket will fall into the 15% capital gains tax rate while a person at the upper edge of the 35% tax bracket will fall into the 20% capital gains tax rate. The reason for this is that the TCJA changed the inflation adjustment calculation from using the Consumer Price Index for All Urban Consumers (CPI-U) to the Chained Consumer Price Index (chained CPI), which provides for lower inflation for the choice that a consumer may make for an available substitute good for a lower price. Hence, taxpayers may move more quickly into higher tax brackets as their income rises.
Suppose the taxpayer decides to continue buying and renovating homes (i.e., house flipping) within a period that is less than two years, which means the homes won’t qualify for the primary residence exclusion. In that case, the gains realized from the sale of the renovated homes will more likely be treated as ordinary income. For example, if a taxpayer is buying, renovating, and selling homes within one year, that gain is treated as a short-term capital gain and is taxed at the taxpayer’s marginal tax rate, which could be as high as 37%. But if the taxpayer is buying, renovating, and selling frequently, he or she will likely be deemed a “real estate dealer.” As a real estate dealer, the taxpayer is now a business, and, like any other business, the gain is taxed as ordinary income regardless of the holding period.
Determining whether a person is a business owner isn’t easy. Treasury Regulation §1.1402(a)-4 provides that, in general, an individual who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales is a real estate dealer. On the other hand, an individual who merely holds real estate for investment or speculation and receives rentals therefrom isn’t considered a real estate dealer. A review of the court cases in this area suggest activity level, turnover rate of properties, and personal conduct are signs of a person’s intent.
Overall, it probably will be the facts and circumstances that will determine if a taxpayer is a real estate dealer or not. Please note that it will be hard for the IRS to overlook the activity if there are a bunch of Forms 1099-S, “Proceeds from Real Estate Transactions,” appearing on an individual’s annual income tax returns. So if the activity looks like a business and acts like a business, it probably is a business. And once it’s a business, the profits made on the sale of the home are treated as ordinary income that may be subject to the self-employment tax of 15.3%, which is applicable to earnings up to $132,900 in 2019.
Ideally, buying, renovating, and selling one’s principal residence can produce no taxes on the gains. Even better, a taxpayer doesn’t report the sale of a qualified principal residence if the gain doesn’t exceed the exclusion amount. But if the transaction doesn’t qualify for the exclusion, then the taxpayer may need to pay capital gains tax or, more likely, ordinary income tax plus self-employment tax. Therefore, it goes without saying that it’s important to consult a qualified tax person to minimize the likelihood of going astray of the law.
© 2019 A.P. Curatola