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Questions From Readers: Flipping Houses as a Hobby

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

Larry
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

Is it a Hobby or a Business?

From the IRS summer tax series. I really love these tips.

Summer is a time many Americans take their fishing poles and gardening tools out of storage. Hobbies – such as woodworking, stamp collecting and scrapbooking – are often done for pleasure, but can result in a profit.

If your favorite activity does make a profit every year or so, there may be tax implications. You must report income to the IRS from almost all sources, including hobbies.

Here are eight questions that will help determine if your activity is a hobby or a business.

Is the purpose of your activity to make a profit? Generally, your activity is considered a business if it is carried on with the reasonable expectation of earning a profit.

Do you participate in your activity just for fun? Hobbies – also called not-for-profit activities – are those activities that are not pursued for profit.
Do you depend on income from the activity? If so, your activity is likely considered a business.

Have you changed methods of operation to improve profitability? If so, your hobby may actually be a business.

Do you have the knowledge needed to carry on the activity as a successful business? People who carry out hobbies just for fun, often don’t have the business acumen to turn their not-for-profit activity into a profitable business venture.

Have you made a profit in similar activities in the past? This may indicate your activity is a business rather than a not-for-profit hobby. An activity is presumed carried on for profit if it makes a profit in at least three of the last five tax years, including the current year – or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.

Does the activity make a profit in some years? Even if your activity does not make a profit every year, it still may be considered a business.

Do you expect to make a profit in the future from the appreciation of assets used in the activity? This indicates your activity may be a business rather than a hobby.

If your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity. If you are conducting a trade or business you may deduct your ordinary and necessary expenses.

More information about not-for-profit activities is available in Publication 535, Business Expenses, available on the IRS.gov Web site or by calling 800-TAX-FORM (800-829-3676).

Link: IRS Publication 535, Business Expenses

Is Your Business Really Just a Hobby?

By Stacie Clifford Kitts, CPA

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?

Links:Publication 535, Business Expenses

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