As with almost anything worth doing it essential to have an ultimate goal and adopt strategies that help you get there. For many of us the long term goal is retirement related. You may have many other short term goals as well that will influence your real estate investing. If you are a good planner then many more investment strategies can be employed.
There are lots of strategies and ways to invest, one strategy that can work well is actually a mixed strategy where some properties are purchased with flipping in mind and other properties are purchased to hold as rentals. You can flip turnkey properties but generally I see investors flipping fixers that need various levels of repairs or improvements. Fixers can often work out as great flips or rental properties if purchased right.
If you have decided to use this mixed strategy you need to be aware of the potential tax risks though. Flipping is generally treated as a business activity and taxed at ordinary income rates while buying property to hold is generally treated as a passive activity. There is no reason that an investor can’t use the mixed strategy, but clearly it is important to separate these activities for tax purposes.
So what must be done to keep these activities separate and enjoy the tax benefits of rental properties while flipping some properties? Most of the time as an investor you know what your exit strategy for a particular property is, for income tax purposes though you need to clearly show that intent to the IRS. That means creating some separation between your flipping activities and your rental activities.
Using separate entities for each activity is a good way to create the separation you need. Often an LLC is a good choice, but every investor’s situation is different and you should get good advice so that you don’t have to change the entity later.
You won’t always know what you want to do with the property ahead of time and it can be advantageous to purchase the property first in your own name and then transfer the property later to the appropriate entity. Timing of the transfer is very important though and you want to make this determination as soon as possible. It becomes more risky tax wise if you wait in making this decision though. A good tax adviser may be able to help you, but don’t wait until after the deal is done or heaven forbid until the year is over.
It is possible to separate your activities and not create two separate entities. I don’t generally advise this, but in can work and for a few, make sense. You will still need to create a way of separating these activities which can be done with separate bank accounts or a good accounting system or ideally a combination of both.
I will leave you with one other thought. When you are fixing a property many of the holding costs will need to be capitalized rather than expensed. There are ways to change the timing of expenses but they must be planned for and waiting for yearend limits your choices
Written by: Charles Perkins