(pleasant music tones)
- [Toby Mathis] Heard something scary on the last Tax Tuesday.
Well, it was close to Halloween
and I was trying to scare everyone.
- [Jeff Webb] Good job.
- [Toby Mathis] I wanted to follow up to ensure
that I wasn't doing something terrible on a flip
I'm scheduled to close next week.
What I heard: If you get identified as a real estate dealer
by the IRS, you get taxed on 100% of the gain
on the sale of the property in the first year,
even if selling on installments.
- [Toby Mathis] Well, alright, so if you're a dealer,
then you do not get something
called installment sale treatment.
Is that 475?
- [Jeff Webb] I think so, yeah.
- [Toby Mathis] I think it's 475.
Actually I could probably type it in here.
Oops, I don't know how to type without a typewriter.
It's 475, I'm reasonably certain.
But what it says is that there's an exception
to being able to designate something
under the installment sale method.
So in other words, installment means
I'm taking money over time.
So if I sell Jeff my house,
and I say pay me over 10 years,
then I'm electing to treat that as an installment sale,
then I am receiving that income over 10 years.
And it's a great way to defer the tax out into the future.
Now if you hold inventory for the resale to the customer,
which is what a dealer does in real estate.
I'm buying real estate.
I'm holding it as inventory, and I'm selling it.
I buy property with the intent to sell it.
I do not get to take installment sale.
Is that a correct statement?
- [Jeff Webb] No, wrong statute.
- [Toby Mathis] Oh which one is it?
- [Jeff Webb] 475 is market to market.
- [Toby Mathis] Darn it!
Alright so I'm thinking about traders.
What's the installment sale?
I'm going to trip myself out here.
- [Jeff Webb] It's not participating.
- [Toby Mathis] I'm going to find out.
I'm going to drive myself crazy. - 453.
- [Toby Mathis] 453, so that's the installment method.
Too many sections running around in my head.
So 453, and the exception to that is the dealer.
So here's why it's really bad to be treated as a dealer
if you're doing this.
You are taxed on 100% of the gain the year that you sell it.
So in real life, I'll give you a real life situation
that happened to a client,
is they bought a piece of property for about $4 million.
They were going to develop it and sell off the pieces,
and somebody comes in, this was actually in 2007,
says hey, I need that land,
and they said well, we don't really want to sell it to you,
and they said how 'about I give you $7 million for it?
They're like oh wow, $3 million gain,
but they said we're going to pay you over time.
They said, good, 'cause we don't want to have to pay tax
on all this money,
and of course think of the timing of it,
they never got dime on the sale,
and the IRS taxed them on the $3 million,
and they said, but they defaulted.
The land ended up not being worth
half of what we paid for it.
All these losses, all this stuff,
and the problem was, it didn't matter.
The taxable event happened
the day that they sold the property
to the guy for $7 million.
It took 'em two years to figure out the project was down.
In that two years, there was interest and penalties
on that non-reported $3 million of income.
So they got slapped around very hard.
They eventually were able to write-off the debt
having reasonably tried to collect it as bad debt,
but that took 'til year three after the sale.
Then they were able to carry back some of those losses,
but it doesn't erase the penalties and interest,
and they ended up out about $300,000
that they never thought,
and their accountant completely missed.
So when they came to use they were like
what do we do?
And I said, well there's nothing you can do
except we got 'em right when they were
trying to collect on the note,
and I said you have to use reasonable methods
to collect the note,
then you have to write it off as business bad debt.
The accountant had dropped him of course
because he was scared of getting sued.
Anyway, so that's dealer.
Now being the president of the S-Corp,
you may be able to be a real estate professional,
does that matter?
The answer is no. - Right.
- [Toby Mathis] Unless you have losses.
Real estate professional status only matters
if you are taking massive amounts of depreciation
on properties and creating losses.
'Cause then you can offset your ordinary,
your active income,
your W2 job and everything else with those losses,
but in this case would not matter.
So how should it be carried out in the future?
Don't do installment sales on flips,
'cause you're not going to get that treatment.
- [Jeff Webb] Right.
- [Toby Mathis] It's going to be denied.
So if you're going to do this,
I wish I had an easy method for you.
What you may want to do is fix the flip,
sell it to something that's going to be owning it
for a longer term period, that's an investment company.
Like you're going to have to be disciplined about it
and hold it for years
and then sell it under installment sale and let it season.
Otherwise, don't do that installment sale.
If they need financing, have them go to a bank.
Or have them go to another lender,
because you are paying tax on 100% of that regardless.
If anybody tells you differently, they're wrong.
Flat out, simple.
You can go read the statute.
It says this is not available to people
that hold it in the ordinary course.
You can go read it yourself,
26 USC, and what'd you say 453?
So, anyway, fun stuff.
So I'm sorry I scared you.
Hopefully we're lessening the beating
you're going to take tax wise.
If you are getting beat tax wise,
it means you're making money.
It doesn't mean that like, this is horrible.
It just means you're not going to pay tax in the future
on that money as you receive it.
The only money you'll pay tax on,
is the interest that you're earning
on that installment note.
'Cause you're going to pay all the taxes.
(relaxed music)
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