In this episode, Toby Mathis, Esq. chats with Jeffrey Cottle, Esq., Senior Attorney at Anderson Business Advisors, about the world of house flipping, with a focus on how to handle the tax implications. It emphasizes the importance of avoiding “dealer” status with the IRS and explores strategies like asset protection. Toby and Jeff discuss limitations placed on frequent flippers and analyze the pros and cons of different business structures like LLCs, C-Corps, and S-Corps. It concludes by examining the most common scenarios Jeff encounters at Anderson Advisors when working with house flippers.
Highlights/Topics:
- Jeff Cottle intro
- Flipping all comes down to ‘intent’ with the IRS
- Avoid “dealer” status, and consider asset protection when flipping
- 1031 exchanges, installment sales are not available to dealers
- Flipping risks increase with each new property you purchase
- Pros and cons to LLCs, C-Corps, S-Corps
- What is the “typical” scenario Jeff sees for flippers?
- Send us your questions and ideas for future show topics!
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Full Episode Transcript:
Toby: Hey, guys. Toby Mathis here, and I’m joined by attorney Jeff Cottle. First off, welcome, Jeff.
Jeff: Thank you, Toby. Thank you for having me and happy to be here.
Toby: We are going to be diving into the world of flippers. This is going to be how to structure your real estate flipping business, if I’m not mistaken.
Jeff: That’s correct.
Toby: All right, let’s dive in. Again, I’ll just set the table. This is a very specific type of real estate investing strategy that involves purchasing and selling. Jeff will get into all that. We’ll go over the asset protection components, we’ll go over the tax components, and then we’ll go over our recommendations for how you structure these all in one quick event. Jeff, let me hand it to you and you just take it away, brother.
Jeff: I really appreciate it, Toby. Thank you. Once again, my name is Jeff Cottle. I’m happy to be here. I’m one of the attorneys at Anderson Business Advisors. What Toby said is exactly right. Today we’ll be going over flipping, and we’ll go over here in just a second, what that entails and the reason we recommend the strategies we do.
What Toby said is exactly right. This is a pretty specific strategy. This is not going to apply to every scenario, and that’s intentional. When we talk with our clients, we want to make sure we customize our strategies and our recommendations based on their needs. But with that in mind, here are a couple of the most important principles that we want to talk about, and bear in mind, when we talk about flipping real estate.
What we’re talking about when we say flipping properties, we don’t quite call it formal definition, but what we’re looking at here is you have purchased a property with the intent to sell it for a profit. That’s going to be the big key there, that intent to resell it. That’s with the IRS when they’re classifying this income, whether it’s going to be earned income, passive income, or whatever else. They’re looking at that intent.
We’ll count it as active or earned income if you did have that intent to resell it. That matters because some people will ask. They’ll say, hey, if I hold the property for longer than a year, does it count as a flip, or can I say it’s a long-term hold now? I’ll say, well, more than a year is helpful. That’s evidence that you may have wanted to hold it for long-term, but it’s not conclusive. It really is the intent.
There’s an old tax court case where some poor fellow had held onto a property for three years, and then he sold it, but the IRS still classified it as active income, classified it as a flip. You say, well, what, why? That’s crazy, and it is. But unfortunately for him, he actually had really, really clear evidence that he was trying to sell the property for the whole time.
Poor dude was just down on his luck. He had the property listed the entire time, he was giving showings, he had agents hired, and all of that stuff. The IRS said, yeah, you held it for a long time, but you were trying to sell it. The intent is pretty clear here. That’s what I mean with intent. You buy a property with the intent to sell. That key, when you have the intent to sell, is going to be that it classifies this as active or earned income. It is treated a little differently.
The other key for that is the IRS, if you do this in your personal name, will consider you a dealer. We’ll go over what that means here in just a second, but these are going to be our two primary concerns that we look at when we’re talking about flipping properties.
The first is that dealer status. It’s actually a negative. We want to make sure we avoid it. Our real estate investors, we want to make sure we’re avoiding that status of being labeled as a dealer.
The second is we really want to consider asset protection when we’re flipping. We always say you want to consider asset protection. That’s right, you do. But especially in flipping, because flipping by its nature, it’s a bit more risky. There’s a bit more involved there. We want to make sure we take both of those angles.
The first one that we look at then is dealer status. I’ve hinted at this a couple of times. What actually is it? When the IRS labels an individual as a dealer, that means that this person who buys and sells properties as a way to earn income, and the key to this, the big important thing that happens is that if you are considered a dealer, your real estate is now considered inventory rather than a capital asset.
Okay, sure. What does that mean then? Those are some accounting or legal terms. What does that actually mean? It’s considered inventory. The big, big pitfall when we have inventory rather than a capital asset is we cannot take depreciation. That’s huge because a lot of real estate investors, that depreciation is big for them. It helps offset income. The depreciation can count against income and lower the taxable income leads to fewer taxes. No more of that if it’s considered inventory.
Another big thing is we cannot do 1031 exchanges. We have other videos that talk in more detail about what a 1031 exchange is. At the basic level, it’s an outstanding tax planning strategy where you can sell a property, purchase a new one, and delay paying your capital gains taxes on that, which is outstanding. It’s a lovely strategy when used correctly. However, again, if you’re a dealer, none of that.
There are a couple of other minor things, but the other big one is we don’t get to do installment sales. When you have inventory, we’re not going to be able to extend out that tax hit if we need to. No installment sales. Here, it’s going to count as a one time purchase essentially with this inventory.
Toby: Just to sink that one in, that means if you’re a flipper, you buy a property or you’re a dealer, you’re buying that property, you’re going to sell it, and you’re going to carry back the note, that means that even though you haven’t been paid, you’re recognizing the entirety of all that income. It’s no longer capital gain. This is ordinary income taxed at your highest bracket. It’s all going to flow onto your return, plus employment taxes in the year that you sold. So you may not even be getting paid.
I actually had a client that got hit with this once. They came to us after the transaction because we never would have let them do it. They bought a property. This will be a fun one for you, Jeff. They bought the property, I think it was in 2007, so context. They were going to develop it. They ended up selling it on a note to somebody. That same year, somebody came and gave him an offer they couldn’t refuse.
They had bought it for $4 million, and somebody bought it from them for $7 million. There was $3 million of gain, and they did it on an installment sale. There were two things that happened. (1) They had $3 million of income in that year. The following year, of course, there was an immediate default on that because real estate just crashed. A year after that, they didn’t know what to do. They didn’t know how to attack this.
They ended up with the property back two years later, in which time then they could actually take the loss on the property. It was a really bad situation. There were two years where they owed taxes and had the interest and penalties accruing, and they couldn’t get away from them.
They just got brutalized by it. You have to be careful of that. I just always find that stuff fascinating. People don’t truly grasp what that means when they’re like, hey, I can’t do 1031. I think that’s pretty self obvious. Hey, I can’t avoid the tax and 1031s were avoiding recapture. It’s like, great.
But here, there’s no recapture because you can’t depreciate dealer property—this is inventory—and I can’t push the gain. There is no gain. It’s ordinary income, so there’s no 1031. That installment sale kicks people in the shins more than just about anything else that I see with these folks. They buy a house, fix it up, carry back the note, and they don’t realize that that’s taxable the year they did it.
Jeff: That’s exactly right. That’s funny that you say that. It was not nearly the same situation, but I ran into something very similar with a client a few months ago who had exactly that, a seller finance deal on a property that they had bought and fixed up, and they had already flipped a bunch of other properties. Same principle there.
That’s funny. It’s evidence of exactly what you said. That’s the one that will catch investors if they’re not paying attention, so absolutely. I could not agree with you more there, Toby. Thank you. That’s the first thing, that’s dealer status. That’s part one of our two primary concerns. We want to make sure we avoid that.
The other is just that flipping properties by its nature is higher risk than having a long-term hold or something else like that. Why is that? It’s because by definition, you more than likely have done at least some work on the property. Does it mean that you have done everything and that every defect or every fault is going to be your responsibility automatically? No, but the buyer has the foot in the door to say, okay, well, I know you did work on this and I know there’s a defect. Boom.
They can come back and say, hey, there’s a leak in the roof. They say, okay, well, I know that the person who I purchased this from did work on it. Therefore, I can come after them for the leak in the roof. Then it becomes your responsibility now to defend that.
Even further, we can add moving parts to this. If you as the investor have not done the work, but let’s say you have hired other contractors, they’ve hired contractors, we’ve got subcontractors, you’ve had the property listed, you’re doing showings, and you have private money lenders, that’s a big thing in flipping too.
Let’s say there’s a delay. You have a private money loan on there for six months of interest-only payments and then a balloon payment on the end, well, golly gee, something went wrong. Now we’re nine months out, and your private money lender is really upset and threatening to file a lawsuit. These are all things that are just more likely to happen by the nature of flipping and just how it goes.
Lastly, most people who are flipping properties, they’ll start with one. If they make a good profit, we’re going to continue doing it. That’s the point, we want to make more money as we’re investing.
With flipping, it’s going to be a higher volume game. With each property that you add, each property that you flip and sell, the risk of something going wrong just goes up and up and up with each one. We come back to that original question. What do we recommend? What do we do to avoid these things?
This is going to look a little basic and reductive, but it’s incredibly effective. What we want is we want you as the investor, as the flipper, as the property owner, to have an entity taxed as a corporation as a parent company, if you will, as you can see on that diagram, and then we will want a child company. You can use a “child” as a subsidiary company and LLC, almost always disregarded LLC, in a local state where the property is actually located.
There are two parts to this, there’s the local LLC and then the corporation. We’ll address each part there briefly. First is that local state LLC. That local state LLC provides protection. You say, okay, sure, but what does that mean? It provides protection for the corporation so that if you’re doing other things with the corporation or you have other properties, it’s protected from lawsuits. Why? Because the property is owned by the LLC.
That’s so important. Let’s use that same scenario again. You’ve bought a property, you’ve done some work on it, you’ve sold it. If you do that in the name of this LLC that is owned by a corporation, then let’s say the buyer comes back.
I actually had a client. The leaky roof unfortunately was on my mind because I had a client who dealt with that recently on a property that he flipped, where he flipped it, fortunately, out of a business entity, out of an LLC, and then, so this buyer came back and said, hey, there’s a leak in the roof.
Our client says, well, okay. He had gone through an agent. He tells the agent, well, they need to take that up with the actual seller. Who was the seller? It was an LLC, it wasn’t him. Therefore, he and his corporation that he had as the parent company were protected in that sense because they didn’t sell the property, the LLC did. That’s what they have to take it up with.
If you have other assets, it provides protection for you personally. If you dissolve it after the fact and that is something that we recommend, it goes even further. Why? Because then that LLC, we have our corporation, we have the LLC, purchases the property, you do the repairs, you sell it, you move the money into the parent corporation, and dissolve this LLC.
What happens is if there is a defect or if there’s something wrong, if the buyer’s looking for a quick buck, again, they’re going after a ghost, a seller that no longer exists. You would have to have done something pretty extreme, actively committed a crime at that rate in order for them to get anywhere. Otherwise, they’re out of luck. That’s intentional.
Again, with this higher risk nature of flipping, we want to have extra protection. That’s why I recommend single LLC, one per property, you sell that flip property, dissolve the LLC. We’re done. That’s the first part, that’s the LLC.
The second then is we have an entity with corporate taxation that can be an LLC taxed as a corporation or a corporation itself. This is where we get at that point we’ve hit on a couple of times now. This avoids dealer status. Why? Because the corporation or the entity taxed as a corporation is a separate taxpayer. This is a little bit of a reductive way to describe it, but it’s true in the sense that, functionally speaking, the corporation is now the dealer and not you.
That’s great. That’s what we want because then you can have your other investment properties. You can take depreciation from them. You also can do installment sales like Toby and I were talking about earlier. All of those things, you can still do if you do your flipping in a corporation because again, that corporation is a separate taxpayer now.
Additionally, we have other things we can add on to that. Corporations have more deductions allowed to them as taxable deductions, especially if we’re using the C-corporation tax status. You can use it to fund retirement accounts if you like as well.
Yes, we will usually recommend C-corporation tax status. There are occasions when we may use S-corporations, but for the most part, it’ll be C. We also have videos talking about that as well, the differences between the two. Then we’ll go ahead and that will be our general recommendation.
Again, the reason we do this, hitting on both of those layers there, is we have asset protection in the local state LLC. We have tax planning protection for the dealer status and other tax planning as well in the corporation. That’s going to be our two parts.
Yes, the implications of this are, do I do a new LLC that I dissolve every time for each flip? The answer is, yeah, that’s our recommendation. That way you have optimal protection again for yourself, for your corporation, for the other properties, for your other assets. That’s how we do it.
Can you have multiple LLCs owned by the corporation, multiple flips at a time? Answer again is yeah, totally. It’s a great idea. Again, they have protection for each of them. This is going to be a cycle that we repeat here, making sure that we hit on those two primary points. First, avoiding that dealer status and tax planning. Second is going to be that protection from this higher risk activity by its nature.
Thank you for joining us today. That’s going to be our basic look at flipping. Of course, we can talk in more detail, talk about your situation specifically, and customize this basic plan to your needs from here. If you’d love to talk with us more, we would love to talk with you.
Please, you can click on the link below or even better, enter the word STRATEGY in a comment, and we’ll be happy to reach out to you. We’ll offer a free consultation with myself or one of our other colleagues here to go over your situation in more detail and answer those questions that you may have.
Toby: That was great, Jeff. Thanks for laying that out. Go ahead and put that in the comment guys. Also, any questions you have for Jeff, we’ll make sure he gets it. If you have questions based on this, the easiest thing obviously is to go into comments and leave a question, or just to set up a free consult so you can get a bunch of questions asked.
I ask that you actually go down in the comments and leave the question because other people could see them as well if you’re willing to ask it so that somebody may have the same question, and we can make sure that it gets handled.
We see this a lot where somebody says, well, my gosh, that’s just a profit center then for a law firm who does LLCs. Just for Anderson’s sake, we do unlimited LLCs. We have packages for folks that are dealers so that you’re not coming out of pocket every time you do it.
Different states are different. In California, we might not use this exact strategy because there’s the franchise tax board. We might use a different type of entity for that to avoid a nasty tax surprise every time you do an LLC. It all depends on where you’re at.
In a state like Florida, there may be another component. We might be using something like a land trust or something else, depending on the scenario, to avoid any situations where it triggers any taxation. It just varies depending on where you’re at, which is why there’s no one-size-fits-all. That’s why you talk to somebody.
Jeff, thank you for doing this. Can I just ask you a couple of questions because it’s always fun?
Jeff: Yeah, of course.
Toby: For those folks that come in, what’s a typical flipper doing? What’s their typical activity? If somebody is sitting out there going, yeah, I only do this once a year, this isn’t for me, what’s a typical scenario? What would you say to that person who might just be doing one or two flips?
Jeff: It’s funny to think about because typical can be a wide range. I’ll say that with the scenario that I described of somebody having four or five flips being repaired at the same time, that’s more rare than it is common. We see obviously a broad range of investors and people here at Anderson.
If somebody says, hey, I’m only doing one or two of these a year, I say, that’s fine. Still, please use this. I’m being genuine when I say that this is how I would do it if I were flipping. Just because coming from the attorney’s side, I’ve seen what happens. I’ve seen the nastiness of a buyer coming down. I’ll tell you, that client I alluded to earlier with the roof leak was so relieved that he had this structure in place.
Even better to validate our strategy here, he had a real estate agent that he was working with too, who complimented him, who said, wow, this was a really great idea. It helped them be able to resolve the issue without our client ever having to step foot into a mediation, arbitration, or any crazy negotiation like that. No, the selling entity was gone. He was absolutely relieved.
It sounds cliche to say, but it’s true that it’s like good insurance. We hope you don’t have to use it, but boy, even if you’re just doing one or two, you will be so relieved that you have this in place if something does come up. No doubt there.
Toby: For the person that lives off of their flips—I saw you had the C-corp in there—for somebody who’s living off it, you can still do an S-corp, but we tend to like C-corps primarily because you can reimburse 100% of medical, dental, and vision. It’s great to have that other tax bracket at 21% to be straight with you.
When you have high net worth folks, they love it. Hey, I can park some money over here instead of getting hit. Some cases, these folks are getting hit at 50% if they’re in California. It’s just crazy. They’re able to keep that at a reduced amount for their flipping activities, especially if it’s in other states. They’re like, yes, let’s do this.
Jeff: Such a relief.
Toby: Again, everybody’s situation is different. I would say to anybody out there that’s, hey, I’m not sure, or hey, I do this activity, I’m not sure if I qualify as a dealer, or here, I’m going to get involved in real estate, here’s what I plan to do, how is it going to be taxed, or how is it going to be treated from an asset protection, how do I make sure because worst thing that could happen, you’re a doctor, you flip a house, they sue the heck out of you, and garnish your wages for the rest of your life, you just want to isolate that liability. I had a tenant’s invitee step on a nail. Million dollars, no joke, and they’re not done.
Jeff: That’s awful.
Toby: Yeah, just silly stuff like that. You’re like, what the heck? All it takes is an invitee, a contractor. Anybody comes in and does the same thing, and you’re staring down the barrel of well in excess of your insurance limits, or they’re saying the insurance doesn’t cover it and you’re going to be fully on the hook. This little LLC is going to be your godsend at that point where you’re like, oh.
For all you guys who say, well, they’re going to see you anyway, they might, but it’ll be dismissed. If you operate it within the realm of, hey, they knew they were dealing with the entity, it operated, it handled the flip, and it was on title, I’m sorry. They could try all day long, but that’s not the definition of when you’re going to have equitable relief under those circumstances. At a minimum, we’re taking that bullseye off you.
Jeff: That’s exactly right.
Toby: Go into comments. All you have to do is write in there STRATEGY. Leave your questions and we’ll get to you. Jeff, thank you so much for coming in and sharing. I really appreciate you doing that. We’ll have to have you on again.
If somebody’s out there listening to this and says, I wish Jeff would cover this topic, go ahead and throw it in the comments as well because we take your comments seriously. If you say, hey, will you go over this scenario, then we’ll make a video on it as well. Jeff, thank you so much and we’ll have you on again.
Jeff: Thank you. It’s a pleasure, Toby. Thank you, everybody.
Toby: Do you have questions about your situation and whether an asset protection or a tax strategy might benefit you? Just type in STRATEGY in the comments below, and we’ll reach out to you for a free consultation. We make sure that we’re answering the questions that you have and put you on the right path.
