A lot has been written about the general taxation of real estate investment property. For example, most people understand that rental income is generally taxable at ordinary income rates. And most people understand, at least vaguely, that you get taxed at a lower capital gains rate on real property you hold for at least a year, and that you can defer that gain indefinitely, provided you use a 1031 like-kind exchange when you sell a property.

A great argument for trying your hand at house-flipping, right?

Not so fast.

If you are a professional, full-time flipper, you may not qualify for that capital gains tax treatment.

Why? Because of a little-understood IRS requirement. If you rely substantially on your flipping profits to generate income to live on, then the IRS no longer considers you to be an investor, but a dealer. And as a dealer, you come under different tax rules. Which means almost everything you read about the general tax treatment of residential real estate investment property is wrong.

Dealers vs. Investors

How? Specifically, if you are classified as a dealer, it’s just like running a retail store: The IRS considers your profits to be ordinary income, rather than investment profits. And that means you get taxed on your profits in the current year. You don’t get to defer them indefinitely, by executing 1035 exchange after 1035 exchange.

The key: Internal Revenue Code Section 1221, defining capital assets. According to the statute, a capital asset is real property used in your trade or business.  In a nutshell, if you are making a trade or business out of buying and selling real estate at a profit, and doing so to such an extent that it’s clear that you are a trader rather than an investor, then you will fall under the dealer rules.

The IRS has similar provisions that apply to auto dealers and professional, active stock traders, as well, and for similar reasons: Capital gains tax rates were not designed to apply to retailers – even if you are a retail seller of something very large. Like a house. IRS Publication 544 contains more information (see pages 11 and 12).

Short-Term Capital Gains

For a hard-core flipper, it doesn’t directly affect the tax rate you’d pay. If you hold investment property for less than a year – an eternity to a flipper – then you have to pay the long-term capital gains rate, which is the same as your ordinary marginal income tax bracket. That is, a maximum of 35 percent for the highest earners among us, but more likely 25 to 28 percent for most people. So it’s primarily a wash in that respect.

The major effect on property flippers is that you are disqualified from using a Section 1031 like-kind exchange to defer taxes on that property. Instead, you have to declare any profits from those sales as income that year – even if you buy another property.

Note, too, that if you have real estate profits designated as income at the federal level, that could have state income tax ramifications as well. Make sure you take both state and federal income tax into account during your cash flow projections.

Self-Employment Tax

If the IRS designates you as a real estate dealer, rather than an investor, you get hit with a double whammy: Not only do you lose the option to do a Section 1031 exchange, but you also have to pay self-employment taxes on your profits – a tax hit of up to 13.3 percent as of 2012. That tax is scheduled to increase to 15.3 percent in 2013, unless Congress intervenes to extend the current rate. The self-employment tax comes in addition to the income tax, though self-employment taxes are themselves tax deductible. That’s a far cry from the indefinite capital gains deferral through 1031 like-kind exchanges and the plain vanilla capital gains tax treatment afforded to investors.

Are You a Landlord?

If you invest some of your portfolio to flip, and also own rental property, pay careful attention: If you flip just a couple of properties, and the IRS designates you as a dealer, they will designate you as a dealer across your entire real estate portfolio. This will cost you dearly when you go to sell any of your other properties: You’ll have to pay ordinary income tax on any gains even on properties you’ve held for years.

To avoid the tax sting, consider holding your flipping properties in an entirely separate entity.

For example, you can hold your rental apartments and rental homes in an S-corporation, and collect rental income as a direct pass-through to your individual income tax return. If you buy a couple of properties you’re planning to flip, hold them in a separate S-corporation. If the IRS deems you a dealer, rather than an investor, the negative tax consequences will only apply to the properties within that corporation. In effect, you have shielded your rental portfolio from the undesirable tax effects of your flipping business.

Separating the two practices with entities also has important asset protection benefits – if the corporation gets sued, only properties within that corporation are subject to a judgment, if you conduct yourself properly.

Installment Sales Prohibited

While investors can do installment sales. and only pay taxes on the money as they receive it, a dealer has to pay taxes up front on any income due from an installment sale. This can cause a real cash crunch if a flipper gets caught unawares: You may have a $35,000 tax bill due on capital gains of $100,000, for example, but only be receiving a fraction of that amount in the first year in an installment sale.

To avoid the problem, consider a rent-to-own deal, in which title is transferred at the end of the process, and not at the beginning.

Avoiding an Unwanted Designation as a Dealer

There’s no set-in-stone criteria the IRS uses to designate just who is a dealer and who is a real estate investor. They look at the overall facts and circumstances, and in many cases it comes down to a judgment call. Here are some criteria the IRS may use to assign you dealer status:

• How many properties do you buy and sell per year?
• How long do you usually hold the properties?
• Do you make major capital improvements?
• Do you obtain favorable zoning law changes while you hold the property?
• Did you subdivide the property?
• Do you maintain a “sales office”?
• Do you maintain a sales staff?
• Do you collect significant rental income?
• Is real estate your full-time job? Or do you receive a full-time income doing something else and real estate is clearly a sideline?
• Are you actively involved in the rehab, renovation and sale of properties you buy?
• How do you advertise?

If the overall pattern indicates you are a property flipper, then you will be designated a dealer, not an investor, and subject to the same tax rules any other retail seller has to abide by.

That’s not the end of the world. Indeed, there are some advantages to being classified as a dealer, as well. Specifically, any losses get treated as ordinary losses. as opposed to capital losses. Ordinary losses can offset a lot more ordinary income than a capital loss, which is limited to offsetting $3,000 of ordinary income per year. If you’re a dealer, these losses are business losses, and deductible against business income on a schedule C, if you don’t hold the property within a corporation.

The exception to the above rules comes when you hold your properties in a self-directed retirement account. If you do, and you stay within the rules, there is no income tax nor capital gains tax due on anything you do – as long as it stays within your retirement account, which could be a self-directed IRA, Solo 401(k), SEP IRA, SIMPLE IRA, or even a health savings account! However, if you use leverage within your self-directed account, the account could be liable for unrelated debt income tax. Contact