The capital gains, exchange rules and installment sales rules apply for properties held for “productive use.” I.R.C. 1234. If you are actively buying and selling real estate on a regular basis, you may be considered a “dealer” in real estate properties. A dealer is one who buys with the intent of reselling rather than for investment. There is no magic formula for determining who is an investor and who is a dealer, but the IRS will balance a number of factors, (See, e.g., Winthrop, Ada Belle v. Tomlinson, 417 F.2d 905) such as:
- The purpose for which the property was purchased
- How long the property was held
- The amount of sales by the taxpayer in that year
- Amount of income from sales compared to taxpayer's other income
- How many deals the taxpayer did in that year
- The amount of gain realized from the sale
“Flipper” Properties May Be Subject to Self Employment Tax
If the IRS pegs you as a dealer, your properties are not “investments” but rather “inventory.” If you are flipping properties, this means the profit will be reportable as a business on Schedule C of your federal income tax return. Thus, the gains from the sale of real estate will be subject to self-employment tax, which is currently 15.3% of the first $72,600. You will have to pay the back taxes due, plus interest. Remember that the back-end profit from a sandwich lease/option is “dealer” income, since you are essentially buying from the owner and flipping to your subtenant. Consider a corporation for flipping properties to avoid the self-employment tax issue.
An installment sale is defined under the Internal Revenue Code as a disposition of property wherein the seller receives one or more payments after the close the tax year in which the sale occurred. I.R.C. 453. Installment sales are reported on IRS form 6252.
A seller may elect to report the gain from a wraparound transaction on the installment method. This is desirable because much of the profit made on a wrap is on paper, not in cash. By using the installment method, the seller can spread out the tax on his profits over several years. In this fashion, the gain is taxed pro-rata as it is received.
Real estate dealers cannot use the installment sales method. If you bought and resold a number of properties on a wraparound, the installment sales will be disallowed and the entire “paper” profit is reported as ordinary income in the year of sale. This re-characterization could be a large “hit” for the taxpayer. For example, suppose the taxpayer bought and sold ten properties on the following basis:
- Purchase: $90,000 purchase price, $20,000 down, $70,000 loan @ 8%
- Resale: $110,000 resale price, $10,000 down, $100,000 wrap note @ 11%.
Thus, in each case the seller receives $10,000 in cash and $10,000 in “paper” profit. He also collects monthly net cash flow of about $440 per month. He pays taxes on the $10,000 cash and reports the balance as an installment sale. He also pays tax on the interest received each year. If the profit on the ten deals is re-characterized as ordinary income, the taxpayer now has $100,000 additional income subject to tax in the year of sale!
If you are doing a large number of installment sales, consider “opting out” of the installment method. The installment method of reporting is not mandatory; you can choose to instead report the entire profit in the year of sale. When opting-out of the installment method, the profit is not based on the sales price, but rather the market value of the note received.
Using the above example, the market value of a $110,000 note secured by a $100,000 property is probably worth about $92,000 depending on the credit of the buyer. Thus, the net value on the note is $92,000 – $90,000=$2,000. You would report a $12,000 profit (the $10,000 in cash + net note profit) in the year of sale, plus interest as you receive it annually on the payments.