| Tax
consequences of flipping real estate | | |
| "I work with many investors
who say, 'We love to pay taxes, because it means we're making money.'" But there are ways to pay less tax on a property-flip
profit. The easiest is the aforementioned capital-gains technique.
Simply hang onto the property for more than a year and you'll pay long-term capital
gains taxes instead of higher ordinary rates. As long as you're planning your
capital-assets strategy, see if you can sell the money-making real estate during
the same tax year that you suffer a loss on another long-term asset. That way,
you can use the loss to offset your gain. Want to avoid taxes
altogether? Move into the investment property and turn it into your primary residence.
As long as you live there for two years (or a total of 730 days -- and the occupation
time doesn't have to be sequential) out of the last five, says Davis, the IRS
will accept that it was your home. Then when you sell it, up to $250,000 (twice
that if you're married and file jointly with your spouse) of your profit is excluded
from taxation. You can also defer tax on your real estate gain
by exchanging it for another property, known as a like-kind
or Section 1031 exchange. "The parameters here basically
can be pretty broad, as long as you trade an investment property, or business
property, for a similar one," says Davis. "For instance, you can swap
undeveloped land for developed land, or vice versa. You can swap a residential
rental home for a commercial property. The only restriction: The exchanged property
can't be a personal asset. It has to be an income-producing asset." Keep
in mind that a like-kind exchange will only postpone your tax bill. When you ultimately
dispose of the investment property you acquired in the exchange, you'll owe taxes. Some
property speculators, incorporate in an effort to reduce or avoid taxes, but Davis
says, "Whether you incorporate, or not, really doesn't change the tax law.
The main benefit of incorporation is that you segregate your business activities
from your personal so there's no personal liability, but incorporating doesn't
change tax consequences." In fact, incorporating could
make tax matters worse. "If you incorporate, that lends more credibility
to the fact that it is a business, because you're letting the world know that
there's an entity out there doing this," says Rucci. Proven
tax-reduction tactic
Finally, when flipping properties, make sure you
follow one of the time-tested ways to reduce taxes: Keep good records. Such documentation
can help you claim real estate investment deductions. When
you invest in a property and then make improvements, those costs can be used to
offset your eventual tax bill. Rucci recommends a separate checking account for
each piece of property. Commingling the costs associated with several investment
properties, or even one investment property and your personal bank account, can
lead to confusion and potential tax problems. Rucci helped
a client who came to the Boston CPA's office for help in answering IRS questions
about three property flips. Rucci was able to convince the tax examiner that the
client was indeed an investor, not a businessman buying and selling real estate,
thus avoiding any self-employment tax assessments. However,
Rucci didn't have as much success when it came to write-offs on the properties.
The client had not been keeping good records of his real estate improvements,
and the IRS disallowed some of the property-related deductions. "Now
that he's our client, he'll be doing a better job in that area," says Rucci.
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