TAX PITFALLS OF FLIPPING HOUSES: Selling a house for a profit can be a nice economic windfall, but the amount of taxes owed for the gain can vary significantly depending on whether the home meets the principal residence requirements, is an investment, or, at worst, is part of a business.

Author:Rinier, James W.
Position:TAXES
 
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TELEVISION AND OTHER MEDIA present a wonderful image about the opportunities for buying houses on the cheap and then quickly selling them for a profit in a rising market, often after renovating them to improve the value. What often goes undiscussed are the tax consequences from this activity of flipping houses. This includes the exclusion of gains up to $250,000 ($500,000 if married, filing jointly) from the sale of a principal residence or the incursion of capital gains tax on the sale of an investment property or of ordinary income tax and self-employment tax from a house-selling business.

SALE OF A PRINCIPAL RESIDENCE

Per Internal Revenue Code (IRC) [section] 121, a taxpayer can exclude up to $250,000 ($500,000 if married, filing jointly) of the gains from the sale of his or her principal residence if certain requirements are satisfied:

  1. The home has been the taxpayer's principal residence for at least two out of the past five years;

  2. The taxpayer satisfies the look-back rule, which means the two-year residency period doesn't overlap with the two-year residency period of a former principal residence;

  3. The taxpayer didn't acquire the home through a like-kind exchange during the past five years (IRC [section] 1031);

  4. The taxpayer isn't subject to expatriate tax; and

  5. The taxpayer satisfied other qualifying requirements, such as not being separated or divorced from his or her spouse during the ownership period and other eligibility tests found in IRS Publication 523.

This allows a taxpayer to buy, renovate, and then sell his or her principal residence every two years and, more importantly, exclude up to $250,000 ($500,000 if married, filing jointly) of the gains from the sale of the principal residence. Better yet, a tax-payer can do this process repeatedly as long as the requirements are satisfied each time.

It's critical, however, that the individual keeps enough documentation to support the claim. For example, a taxpayer can only have one main home at a time. If the taxpayer owns or lives in more than one home, then a facts-and-circumstances test will apply The most important factor is where the individual spent the most time, but there are other factors that the IRS may look at to determine the principal residence. These include the address the person uses to receive mail as well as his or her voter registration, federal and state income tax returns, and driver's license and vehicle registration. Moreover, it isn't just the...

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