How Real Estate Investing Is Taxed

The following was conversation between my tax strategist and I. This is for informational purposes only and is not legal advice. Always seek the assistance of competent professionals!

That said here you go:

Hi Matthew, I will try to give a short answer to what could be a lengthy discussion.

There are several different concepts that are similar in nature, but still different concepts.

investor vs. dealer status typically deals with investments. Real Estate, although is an investment is looked at differently, and is real estate. That being said, there are different aspects of real estate. Rental activities, development activities, construction activities etc.

Rental Activities - are passive income - not subject to Self Employment tax by its nature and treated as ordinary income or loss. (There are special rules for material participating real estate professionals to get around the passive activity loss rules)
The sale of a rental property is treated as a section 1231 asset, which gives rise to capital gain if sold for a gain and ordinary loss if sold for a loss. Depreciation deductions will be recaptured as Section 1250 recapture and taxed at a maximum rate of 25%

Flipping of real estate is a different issue. This would be similar to development activities. If an asset is held one year or less and sold, the gain is short term and taxed at ordinary rates. If an asset is held longer than one year, it depends on the nature of the activities associated with the asset as to the treatment of the gain. For instance, if bare ground is purchased and improved - platted, streets, utilities etc. and sold with a holding period of longer than one year it would typically give rise to trade or business income (ordinary income) since it was sold in the ordinary course of real estate development business. This is the same classification a home builder would have if a house sat unsold for longer than one year since they are in the business of building homes.

If a person is in the trade or business of buying properties, rehabbing the property and selling the property the IRS would most likely classify any gain as trade or business income and tax it at ordinary rates. However, if a person buys properties, rehabs the property and rents it, then it becomes a rental property. Should the property ever get sold, it would give rise to capital gain and be taxed at capital gain rates.

The other aspect of the flipping transactions is the frequency and regularity that they are being entered into. The higher the volume of transactions, the more it appears to be a trade or business.

Typically flipping transactions are more short term prospects held one year or less and would give rise to ordinary income. If a property will be held more than a year it will quite likely be rented, which would give favorable tax treatment.

Additionally, a section 1031 exchange could be entered into in order to roll over gain from one property to another. There are certain time requirements to consider and comply with in order to facilitate the exchange, but this can also assist in keeping taxes minimized.

I think you were on the right track, however the are several similar concepts that may be getting intermixed. I hope this helps. Let me know when you want to get together to go over the sale, or if you want to ahead of time to possibly discuss exchange transactions.

Let me know if you have any questions - Mike