If your first house-flipping project ends in a loss, don’t assume you’re limited to deducting only $3,000 per year as a capital loss. Depending on your specific facts, you may qualify to deduct the entire loss in the current year.
The key issue is whether the IRS views you as a real estate dealer or as an investor. Investors generally face the $3,000 annual limit on capital losses. Dealers, however, report their activity as a business, allowing losses to offset ordinary income in full. In many cases, dealer treatment will also result in the payment of self-employment tax.
Qualifying as a dealer depends on more than the number of properties you have sold. The IRS and the courts look at your overall business intent and activities. Factors include:
why you purchased the property, the extent of your rehabilitation work, how quickly you marketed the property for sale after renovation is complete, and whether you conducted the activity in a businesslike manner.
The timeliness of putting the property on the market is an important factor. An investor may opt to wait until a soft market returns to a more profitable opportunity. A dealer is more concerned with selling the property quickly to get the cash necessary for the next project.
But dealer status is not always an advantage. If future flips generate profits, those profits become ordinary income rather than capital gains. Dealer property also does not qualify for Section 1031 exchanges or installment-sale reporting. So, for properties where you make a profit, you will be sharing more of that profit with the IRS and (in CA) the FTB!!
Keep in mind that you cannot flip your classification. In other words, you cannot be a dealer in loss year (to take advantage of a fully deductible loss), and an investor in profitable years (to get the benefit of the capital gain rates).
If you intend to build a house-flipping business, good records are essential. Maintain a written business plan, keep separate books and bank accounts, track your time, and consistently report the activity as a business from year to year.
You really should talk with a tax professional before getting into the business so you better understand the consequences of dealer vs. investor status – and what you need to do to achieve dealer status if that is your goal.