Today I received this question from a reader about flipping houses.
Although I’m in Missouri, there appears to be a great deal of buying of foreclosures and selling at a profit in California. The question I’ve seen asked but not answered is, “Is that a capital gains investment or a business interprise requiring the payment of self-employment tax?”
I am retired at age 65. I have long been interested in real estate and recently purchased a house as an investment/retirement activity at a foreclosure sale. To my surprise, I quickly found a buyer for it this month with a profit of about $15,000. (Our “normal” yearly income from pensions and social security is about $60,000.) I would like to continue buying, repairing and selling 2 or 3 properties a year as a profitable retirement “hobby”, but after learning that there is a risk that the IRS may consider my “flipping” a business activity that includes self-employment taxes, I am reluctant to continue.
Are you aware of any guidance from the IRS to better define this issue. Under what circumstances does the IRS decide an investment becomes a business activity?
Thanks for your input, Larry
Here is my reply
This is a complicated area. If you are engaged in this type of activity, you should hire a qualified tax professional to assist you with your tax questions.
As far as a general discussion, here are some things to consider.
Generally, flipping houses falls under a business with ordinary income aspects that would subject you to self-employment taxes. The houses that are flipped are considered inventory, which would not get capital gains treatment. What you are looking at here is really a facts and circumstances test with regard to the activity.
Whether you pay self-employment taxes is dependent on many factors such as the business entity that you will be operating from. Some entities might require that you get a W2 which will require payroll taxes be withheld. In addition, the business entity will be required to pay the appropriate employer portion of the payroll taxes. Other entities will require you to pay self-employment taxes on your income and still others may allow you to pass-through some of the income without any self-employment or payroll tax issues.
You should be aware that profitable hobbies are subject to income tax where losses from a hobby do not get you a tax deduction.
If you are looking for the rules on the tax treatment of a particular transaction, I encourage you to speak with your tax advisor before you enter into it.
I also found this interesting and helpful article by Kay Bell writen for Bankrate looks like it was picked up by Yahoo. Check it out if you want more information. Tax Consequences of Flipping Real Estate
Do you know the difference between a hobby and a for profit business? If you don’t know the answer to this question you should take some time and familiarize yourself with the “hobby loss rules” under Internal Revenue Code Section 183. This code section explains that activities that are not engaged in for profit – are limited in the amount of deductions that can be taken.
The deductions that can be taken for a hobby activity are limited to the amount of income generated by the hobby. Therefore, hobbies cannot generate net operating losses.
Here are some factors that may help you determine if your business is really a hobby:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?