Free Educational Video
What Expenses Can I Deduct When Flipping a House?
Total Watch Time: 10 Minutes and 47 Seconds
What Expenses Can I Deduct When Flipping a House? – Video
Skip: There’s a lot of confusion on renting versus flipping. Tax treatment on renting versus flipping properties, very different. Very different going in, very different as you’re going through it, very different when you get to the end. You got to think of your properties in two different categories. If you have a property that’s held for rent, it’s a rental property. Most of us are pretty well familiar with how that works.
Everything’s coming through on your Schedule E, you’re generating passive income or passive loss on that property. Property developed or rehabbed for sale, now, you’re dealing with what’s typically referred to as a development or a flip property. Your tax treatment here is very different and it has to do with intention. How do you know when you own a property if it’s a rental property or if it’s a flip property? Well?
Participant: You get rent.
Skip: Yes, do you get rent? You could have a rental property that’s vacant. A lot of it has to do with your intent and sometimes this changes back and forth so you have to work with the accountant to document what it is that you want to show up on your tax return as being what your intent is. The reason for this, there are multiple, but with a flip property you have what’s called dealer status. That real estate isn’t treated as real estate anymore, it’s treated as if it’s inventory.
It’s like you’re buying and selling widgets. You buy the widgets, you put them on your shelf and they don’t generate any tax benefits, they just sit there until you sell them on. Same is true with your real estate, except your basis keeps going up as your costs go up. While you’re allowed operating business expense deductions for the operation of your business, your accounting costs and some of your office costs, anything that’s going into that property and I mean anything. Your property taxes.
“What do you mean I can’t deduct my property taxes?” “No, you can, not if it’s a flip property.” “Can’t deduct your property taxes.” “What about my interest? I’m paying interest on this thing.” “Sorry, all your expenses associated with that property until such time as you get to the point where you either sell it or you can rent it to a rental, they’re all going to be capitalized.” I’ve had taxpayers come and tell me about how much they’re going to save all this money, because they’re going to have all these expenses on this renovation that they’re doing.
Wait a minute, let’s talk about this. You have to be careful because generally speaking, the lion’s share of everything you’re spending on that property while it’s being rehabbed, is going to be capitalized. At such point in time as you convert it to a rental, you need to know the exact day that property is first available to rent. As the lady mentioned, you may or may not be receiving rent on your property, but you’re able to convert that property from a rehab to a rental property on the date that it is first available to rent.
That’s when you start taking depreciation and that’s when the door opens for your deductions. That includes your travel deductions going back and forth that Bob was mentioning. It’s very important that you know and document, have the real estate ad, or the signs, or whatever you did to document the date on which it was converted to rental property.
Now, you’re starting your holding period for capital gains. If you’re looking to turn that property as a capital gain asset, it’s got to be a rental property and you have to hold it as a rental property before you sell it. When you sell a flip property, it’s ordinary income straight and clear, it’s like you sold that widget off the shelf. That’s ordinary income coming in, that’s not even a capital asset, it’s considered your inventory.
However, once you convert it to a rental property at that date, it’s as if you bought it on that date for your capital gain purposes, because that’s the date that it became a capital asset and that’s the date from which you start calculating your one year holding period. It used to be that we would advise our clients, “Hold it for a year, after a year you’ll find you’re going to get capital gains treatment.” That was true for a long, long period of time.
In their ultimate wisdom, the IRS has decided to create what they call a safe harbor, which they have selected two years. They’re saying, “In this case we’re converting a flip property to a rental property.” If it’s been a rental property for at least two years, they’re not going to go back and question your intentions and whether or not it was really a flip, but if it’s less than two years they can question it.
What I would advise you is that if it’s convenient and it works into your plans to hold it for two years, that’s the safest. Do keep it as a rental property for at least a year, and make sure that your documentation supports the fact that you consider this a rental property. If you got emails going back and forth to the managers that’s saying, “Yes, I just converted this to a rental property but I’m going to sell it, so I’m going to hold it for a year.”
The IRS has the ability to get to those documents, and if they put their hands on that one, you’re dead meat, because it’s your intention that counts here. Make sure that you’re documenting the fact, that you are in fact holding this is a rental property, it’s your intention to hold as a rental property. You held it for a year and a half and something changed, you want to take the money and put it in a different location or whatever your reason is. There’s a reason why you’re not going to be holding it as a rental property any longer.
Your flip property activities, again, assuming that you actually flip it and you’re not converting it to a rental. If you flip it and sell it, it is not passive. Is not passive, it’s not subject to the 3.8%, it’s considered an active trade or business.
Quick on note investing. Note investing can be done either as individuals or as a syndication. The accounting treatment on note investing is fairly straightforward. Why are you investing in the note? You’re investing in the note because you’re going to get interest income. What is interest income? Well, it’s investment income, it’s portfolio income, it’s interest income just like any other interest income.
The accounting and tax situations change dramatically if you are required to foreclose. One of the benefits of holding a trustee is if things don’t go right, you have the ability to access the property. I will second what Bob was saying earlier, that if that property happens to be in California that can be a difficult task. There are other states that are much more easy to foreclose on a property than in California.
Once you do foreclose, now, everything shifts and you’re no longer a note holder with investment income and interest. You are now an owner of the property and you got the same situation that you have with your other rental properties. Whereas the date of the foreclosure would be treated as the day in which you bought the property. You don’t get to count the time that you held the note as the time that you held the property for purposes of capital gains or any other holding period purpose that really starts at the point in time of the foreclosure.
I’ve known some people that have made some very good money doing this. This isn’t always a bad thing. For the most part investing in trust notes is fairly straightforward. You’re investing, you know what your interest rate is going to be. You get it because the terms of the thing are set up, that the people would be crazy not to pay the note on time so they pay note on time and all is well.
If you should happen to be involved in a note transaction where there is a loss, for some reason that particular section of the real estate market totally crashed, or whatever happened. You were able to foreclose but you weren’t able to recover your funds back entirely, you have loss. That’s treated as a capital loss. Now, you’re looking at the $3,000 a year issue, so just be aware. It’s an investment activity not an operating business. Accordingly, with an operating business you are deducting your office expenses, you’re deducting travel expenses, you’re deducting a lot of operating type activities. Know that if you’re invested in a trust deed your deductions are limited to investment rules, which basically means you do not have an operating business. You don’t get operating deductions associated with that trust deed investment.
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