Real Estate Flipping – How to Land on Your Feet
Under Section 162(a) of the Internal Revenue Code, a taxpayer is allowed to deduct ordinary and necessary expenses of a trade or a business that occurred during the year. Furthermore, Sec. 262 prohibits the deduction of personal, living, and family expenses.
While a taxpayer might think that he or she is complying with the tax laws, there have been recent court cases in which individuals considering themselves real estate developers have been fined and prosecuted for failing to meet the IRS’s definition of a trade or business. In addition, a real estate investor whose real estate activities are deemed passive will only be able to deduct passive losses to the extent of passive income, essentially deferring any net losses. For these reasons, it is critical to appropriately identify whether or not a taxpayer’s real estate investment is passive or for a trade or business.
The Internal Revenue Code does not define trade or business, but the Supreme Court has ruled that in order for a taxpayer to be engaged in a trade or business, he or she must participate in the activity on a continuous and regular basis, and the primary purpose of the trade or business must be to produce a profit.
Though these rules help narrow down the IRS’s requirements for a trade or business, they are still very vague. It is important to note that many of the claims filed by the IRS deal with the flipping of residential property as opposed to commercial property. This is because most residential properties have significantly lower start-up costs than commercial properties, allowing virtually anyone to invest in residential real estate. Since anyone can invest in residential property, the tax code is much more likely to get misconstrued by taxpayers who do not consult a professional and who may try to both profit from, and live in, a residence.
While neither of the above rules defining a trade or business prohibits the real estate developer from living in a property, this is generally used by the IRS to rule the taxpayer in violation of the primary purpose test. Using the property personally, for even a short period of time, can result in scrutiny by the IRS.
A few additional tips to consider:
- “Continuous and regularly” refers to buying and selling real estate. Merely renting out a property does not meet the “continuous or regularly” requirements of flipping.
- If the IRS files a claim against a taxpayer, they will look at whether the taxpayer has bought or sold property in the years prior to or after the year at issue.
- If a real estate investment does classify as a trade or business, well-kept, real-time records must be maintained in order to substantiate a deduction.
- A taxpayer may be liable for any deductions claimed, even if the return was prepared by a CPA.
Need More Information
If you have any questions about this real estate update, please contact your WithumSmith+Brown professional or a member of WS+B’s Real Estate Services Group.
Rebecca Machinga, CPA, Partner
Practice Leader, Real Estate Services
609.520.1188
[email protected]
The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your individual facts and circumstances.
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