Interesting ruling regarding house flippers

[WhiteOleander]

This is an excerpt from the Kiplinger Tax Letter. There has been some discussion on whether or not the real estate flippers can claim the sales on Sch D or as business income. This is a recent Tax Court ruling:

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Bad news for folks who “flip” properties: Their profits are ordinary income,
not capital gains, the Tax Court decides. A couple bought four to eight homes a year,
usually ones in foreclosure. They rehabbed the properties and resold them quickly...
normally within two to three months. For tax purposes, they are dealers in real estate.
Thus, the profits can’t be used to offset capital losses (Garrison, TC Memo. 2010-261).
(from Kiplinger Tax Newsletter)
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[geekgirldany]

I faced this same situation a few years ago. I think I actually posted on here about it. Clients had bought 2 houses one year and had not sold. Their plans were to continue buying and flipping quickly. Told them that would be ordinary income. Did not like what I said and went to someone else.

[Corduroy Frog]

Me Too

Client told me he was "in business." Therefore he wanted all deductions deductible for a "business." His business was refurbishing houses, and he did a couple until the economy got him caught with huge losses.

I agreed with him wholeheartedly. After all, he would not get the full benefit of deductions if he had considered them "investment" properties. He did not want the nebulous deductibility of a 2% haircut or the 4952.

Howled like a stuck pig when his sales went on a Schedule C in the first two profitable years and he had to pay self-employment tax. But you can't have it both ways. I agree with the court ruling.

[JoshinNC]

The crux of the issue still comes down to intent

If you read the TC decision one of the mitigating factors the Court utlized in determining whether the activity was "capital" or "ordinary" was that the TP did not hire an RE agent to assist in transactions and that TP did most of the work. A TP that has a bonified full time job, utilizes an RE agent to buy/sell properties and hires contractors to make improvements may be able to get CG treatment. Do agree that if TP wants to be able to deduct expenses as incurred, whethera sale occurred during the period or not, then TP is setting themselves up for SE income.

[Burke]

A TP that has a bonified full time job, utilizes an RE agent to buy/sell properties and hires contractors to make improvements may be able to get CG treatment.

Disagree. The intent is to purchase property for resale. Whether he even fixes them up or not, or whether he uses a contractor to do so or not, to me is immaterial. Also whether he has another job or not -- the same. It's a business and ord income.

[JoshinNC]

So a stock purchased for resale within less than 12 months goes on a Sch. C?

Disagree. The intent is to purchase property for resale. Whether he even fixes them up or not, or whether he uses a contractor to do so or not, to me is immaterial. Also whether he has another job or not -- the same. It's a business and ord income.

I don't think you could agree with that statement, could you?

[newbie]

So a stock purchased for resale within less than 12 months goes on a Sch. C?

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I don't think you could agree with that statement, could you?

IMO the difference is you buy the stock to appreciate, capital gain treatment. You buy the real estate to fix up and sell for a profit. The intent is to put work into the asset either yourself or subcontractors so value increases by physically doing something to the RE not because the value appreciated during the time you hold onto it.

[taxxcpa]

House flipping

I consider house purchased for fixing up and reselling as inventory until sold.
I had one client who fixed one up with that intent, but could not sell it so they rented it.
In that case I considered it converted to a rental property and removed it from inventory.

[JoshinNC]

OK, so let me give you another example

IMO the difference is you buy the stock to appreciate, capital gain treatment. You buy the real estate to fix up and sell for a profit. The intent is to put work into the asset either yourself or subcontractors so value increases by physically doing something to the RE not because the value appreciated during the time you hold onto it.

I manage an investment partnership (a hedge fund, a mutual fund, a limited partnership, whatever) and I but 100% of the outstanding stock in a company, taking it private. I then install my own management team, restructure operations and sell 100% of the stock back to the public, all in the same 12 month period. I get STCG treatment (ordinary income, no SE tax), but I bought the stock with intent to "fix up and sell for a profit". I also "put work into the asset" by "physically doing something to the" company. What is the difference?

I'm not disagreeing with everyone's comments, I'm just trying to show the inconsistency that this ruling may have with common treatment of other "investments".

[newbie]

I think we'll just have to agree to disagree

Why couldn't you say the same about the used car salesman next door. He has a full time job at the factory and on the side he buys and sells used cars. He looks for good deals and has the highschool auto class clean up the engine and gives the highschool football team a donation to shine and polish them. I would consider the cars as inventory and the profit schedule C.

Real estate would be similar if one is "flipping" for profit. The real estate is your inventory.

[Snaggletooth]

Refurbishing Stock

I manage an investment partnership (a hedge fund, a mutual fund, a limited partnership, whatever) and I but 100% of the outstanding stock in a company, taking it private. I then install my own management team, restructure operations and sell 100% of the stock back to the public, all in the same 12 month period. I get STCG treatment (ordinary income, no SE tax), but I bought the stock with intent to "fix up and sell for a profit". I also "put work into the asset" by "physically doing something to the" company. What is the difference?

Josh, there may not be any difference, and this stock may be the equivalent of inventory in your scenario. In effect you are not just buying and selling the stock, but you are subjecting the stock to your own refurbishing and recharacterization. This arrangement may be Sch C stuff instead of Sch D.

[JoshinNC]

Snag,

This is the typical private equity/hedge fund model, and I can assure you that those funds and their managers do recieve CG treatment on these investments, not ordinary income. I am just trying to apply consistency throughout the Code, and this ruling does not meet the consistency test, in my mind.

[Jesse]

This is the typical private equity/hedge fund model, and I can assure you that those funds and their managers do recieve CG treatment on these investments, not ordinary income. I am just trying to apply consistency throughout the Code, and this ruling does not meet the consistency test, in my mind.

Perhaps you could look at the inconsistency in the other direction, that is, these private equity/hedge funds and their managers should not receive the capital gain treatment because they are not just buying the stock anticipating appreciation and then selling the stock, but as Snaggletooth pointed out, they are subjecting the stock to the refurbishing and recharacterization.

[joanmcq]

The treatment of hedge fund manager's income as capital gains is a big loophole in the tax code that the administration has been trying to fix. It was up for revision in Obama's proposal, but lobbying by the deep pockets of hedge fund managers (they have a lot of dough since they don't pay much in taxes!) kept it out of any of the revisions. It was one of the things that the anti-tax increase interests fought against.

[JoshinNC]

I don't want to devolve into a philosophical argument

as to whether private equity funds and their managers should receive LTCG treatment, but I am glad that at least two knowledgable people agreed that that is the case, and that they are essentially doing the same thing as a house flipper. This is my point, the ruling is inconsistent with current treatment of substantially similar income, which indicates to me that there may be some challenges to this ruling down the road due to these inconsistencies.