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Long-term gain vs short-term gain on investment real estate property vs "flipping"

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Level 1

I know that there are nuances regarding the tax laws that surround flipping of houses and that a dealer is different than an investor.  Also, my research has found that the tax treatment can depend on a case-by-case scenario.  Unfortunately, my research is still coming up short on my specific situation.

A client purchased a home in 2017 with the intent to fix it up and rent it out.  About 98% of the work was done by himself and his friends over the last few years.  His total remodel/fix it costs (exclusive of the original 2016 purchase price) are $140k. Of the $140k, $90k was incurred within the 12-month period prior to the sale of the property in April 2019.  Due to the current local real estate market and his own personal financial situation, he changed his mind and decided to sell the house and not keep it and rent it out.  The net taxable gain on the sale of the property is $118k.

I cannot definitively find out if the entire gain is long-term or if it has to be split because of the fact that almost 65% of the remodel costs were incurred within 12 months of the sale.

Thank you.

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Level 12

The difference isn't long term vs short term. It's capital gain vs income.

There is:

Primary residence: buy and perhaps fix, and live in.

Own and operate rentals: buy and perhaps fix, and rent.

Flip: buy and fix and sell. This comes in two flavors:

As Sched C or other business entity reporting = you intend to do it as your business or side hustle.

As a one-off, that isn't business and isn't residence, but is investment as Sched E.

 

If you buy, fix and live in it, you have your total cost as basis. If you buy, fix and rent, you have your total cost as basis. If you buy, fix, and sell, you still have your total cost as basis. Nothing changes about the total value invested.

What did they do for tax reporting in the other years, while still owned and not occupied (not a primary residence and not a rental)?

For the funds invested, that is work in process as Asset value; think of this as Inventory or buying shares of stocks that you hold. Purchase cost and improvements are all part of basis.

I've never seen anything that requires a qualification such as "almost 65% of the remodel costs were incurred within 12 months of the sale" or that $90k was in the 12-month period prior to the sale. Are you trying to make this two different assets? There is just the one property.

You have Basis from the purchase cost (in 2016 or 2017?) and adding to that is the Improvements that are increasing the total invested. Sold in April 2019 means held for more than one year.

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Level 1

Thank you, qbtechmt, for your response.

The LT vs ST can come into play because, like you said, the difference is capital gain vs income.  Since the situation deals with a capital investment, one could take the position that it could be similar to purchasing a stock (another capital investment) and reinvesting the dividends.  Those reinvested stock dividends, if sold prior to a 12-month holding period, will be treated as a short-term capital gain and thus, taxed at a different rate than the long-term capital gains tax rate.  My goal is to try and discover that there is no "fine print" in the tax code when it comes to the situation that I described.

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Level 10

The Devil's in the details.  See if you can find Rev. Rul. 75-524 (yes, it's 45 years old.)

I was not successful finding it online but found lots of references to it that may be on-point for your situation.

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Level 12

@rbynaker 

I read a few references. Thanks for the lead. Here's one:

https://rsmus.com/what-we-do/industries/real-estate/selling-property-originally-constructed-for-use-...

 

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Level 10

Thanks for finding that one, breaks it down into plain language better than most I found.

IMHO, still way too many unknowns here to reach any particular conclusion.  The OP mentioned that the intent was to fix and rent so that probably rules out inventory treatment (which would be "fix and sell").  But that also doesn't scream "trade or business" either.  The intent could be to hold for the production of income instead of to operate as a T/B.  I'm not sure that changes the treatment, but I'm not sure it doesn't.  We also don't know what stage of completion the improvements were in.

Rick

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Level 12

"still way too many unknowns here to reach any particular conclusion"

I agree; NMI.

The question I asked regarding how it was treated in the interim year(s) never got answered. And the values were not provided, so there is no way to determine how significant the improvements were, nor the property type (nice lot, dilapidated existing house?), nor if this person has other rental properties or has done other flips, etc. Too many unknowns and lack of perspective.

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Level 1

Many thanks to rbynaker and qbteachmt.  A quality discussion and good references.

I did give the values of the total additional costs and the amount of costs incurred within the twelve months of the sale in my first post.  The value left off was the original purchase price of $318k (I don't have the exact number in front of me at the moment).

The taxpayer is not in the business of flipping and has one residential rental property and one commercial rental property.  The total time period was about 2.5 years and in the interim years, costs were incurred and recorded in order to be capitalized.  There was no reporting of rental income nor rental costs in the interim as it was not in a condition to be rented.

Income is income (just the classifications change).

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Level 12

Facts and circumstances means the initial cost and condition matter.

Here's what the fuller picture seems to show, then:

They bought it in 2016 or 2017; sold in 2019.

"About 98% of the work was done by himself and his friends over the last few years."

That progress never had any one stage considered completed. That's why I don't see bifurcation here.

"His total remodel/fix it costs (exclusive of the original 2016 purchase price) are $140k. Of the $140k, $90k was incurred within the 12-month period prior to the sale of the property in April 2019"

You stated this: "because of the fact that almost 65% of the remodel costs were incurred within 12 months of the sale."

The $90k is 17% of the total basis in the project that has had 2.5 years of progress and the "65%" nor the "$140k" is not even a phase of completion that can stand alone.

Further, it's doesn't seem the land and building, separated, have different clocks, either. Not if the intent at purchase, up to time of sale, was to improve and rent when completed, similar to the routine operation this person has ongoing.

Again, it would be different if the starting point had been, for examples:

Nice land but dilapidated building

Real Estate bought to be improved to create different sellable portions

Building improvements completed in discrete phases

Any part placed in service over time

 

By the way, I am coming at this from the perspective of an equity investor in similar projects. For instance, we bought a "church" building that had been the tire shop behind a car dealership (clear storey building) and turned that into 3 residential and 3 commercial condos. That is Phased improvement.

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Level 12

We started with the question of Income or Not Income. If it is income for the operation, then capital gains is a moot topic entirely. It seems that a decision has been made on this point, then?

Buying a property, developing it into condos that each sell over time... that is when various holding periods might come into play.

I still don't see how any bifurcation applies to this one property. There is only one real property. It was undergoing construction over time. No part was ever completed and placed in service, prior to the sale of the entire property. No partial asset was sold.

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