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 on to 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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