When investing in real estate, it is important to understand what the tax treatment on the sale of the property will be. Depending on whether the taxpayer is considered a real estate investor or real estate dealer, the tax rate paid on the gain can vary greatly.
Typically, regardless of whether it comes from a sale of stock or real estate, investment profit is considered capital gain income. Capital gains are taxed at preferential rates based on the holding period of the asset. If you hold the asset for less than a year, the gain will be short-term and taxed at your ordinary income rate which can be as high as 39.6%. If you hold the asset for more than one year, the gain will be long term and taxed at the capital gain rate which can range from 0%-20%.
The normal investment income rules can be different for individuals who actively purchase and flip real estate on a regular basis and are considered a dealer. When you complete several real estate transactions in a short period of time, the IRS might consider your transactions as a trade or business rather than an investment. For these people, the real estate they buy and sell might be treated as their inventory, rather than a capital asset, and any gain on the sale of the properties is treated as ordinary income. Not only is this income taxed at the higher rates, it is also subject to self-employment tax. The treatment must be determined on a property by property basis based on the facts and circumstances of each project and the intent of the taxpayer.
As there are no clear guidelines from the IRS or set number of transactions that move a taxpayer from an investor to a dealer, some important questions to ask yourself are:
- How many flips were done this year?
- Is flipping homes a part-time or full-time job?
- What percentage of the seller’s income is earned from flipping houses?
- Is the seller a real estate professional?
One way to avoid paying taxes on the gain all together would be to move into the purchased investment property and make it your primary residence. A married filing joint taxpayer is able to exclude $500,000 of gain on the sale of their personal residence. The taxpayers must have owned and lived in the home for a period of at least two of the previous five years. The taxpayer cannot use this exclusion more than once in each two-year period.
If you are active in the real estate business, it is important to remember to always keep detailed records. Any improvements made should be documented and tracked in order to claim them as deductions. It is a good idea to keep separate bank accounts for each property to avoid any confusion and potential tax problems. It is also important to consult with your tax advisor to determine the correct tax treatment.
For more information, please contact Caroline Blanco, Tax Senior at 206.382.7799