NEW YORK — Amateur "flippers" in the real-estate market have more to worry about than a bubble burst. An IRS audit, for instance, might interrupt their trip up the property ladder.
The popularity of "flip deals" has made section 1031 of the Internal Revenue Code popular with real-estate speculators. In a 1031 exchange, a person who sells a hot piece of business or investment property can defer taxes by immediately rolling the gains into a similar piece of property.
The trouble, tax experts say, is that people don't understand the rules. Many trust the advice of real-estate brokers, who often aren't well versed in tax law.
With the market still hot, some amateurs are buying and selling properties too quickly, running the risk that the IRS may deem the transactions a person's trade or business, with gains taxed as ordinary income and subject to self-employment taxes.
Novice real-estate speculators, especially those who attempt like-kind exchanges, should make sure they understand the rules before they're ensnared in an audit, or forced to pay more than they bargained for come tax season.
"I would certainly say there'll be more scrutiny as the 1031 becomes more popular," says Lonnie Davis, a certified public accountant and director of CBIZ Accounting, Tax & Advisory Services in Plymouth Meeting, Pa. "The IRS has been pretty good about policing abuses lately."
Earlier this year, the IRS announced a crackdown on tax fraud and money-laundering schemes that have proliferated as a result of the booming real-estate market.
"The IRS hasn't looked at the like-kind exchange before," says Eric Kea, a tax partner in the real estate practice at BDO Seidman in New York. "We're assuming they're going to, seeing what the market is."
The best way to avoid a problem is to consult a CPA or tax attorney before you begin the real-estate transaction, as mistakes can be costly.
In the like-kind exchange, if you replace a property used for business or investment with a similar property, no gain or loss is recognized at that time under 1031. Most people do a "deferred" like-kind exchange, where a seller has 45 days to identify a replacement property and 180 days to close on the new asset.
The big novice mistake, tax experts say, occurs when the seller takes possession of the cash proceeds of the sale. Under IRS rules, the money must be placed in escrow or held by a qualified intermediary (such as a trust company), until the replacement property is acquired. "If you take possession, you are essentially disallowed the use of 1031," Davis says. "That's one of the areas that's easiest to go afoul."
To avoid taxes, you have to roll the proceeds into a similar property, which generally would be a business property or land. You can't swap an investment property for a personal asset, such as a primary residence or a vacation home, Davis says.
Bill Abrams, a tax attorney with Abrams Garfinkel Margolis Bergson in New York, fields questions about like-kind exchanges on a daily basis, mostly from clients who get turned on to the idea by real-estate brokers. "Everyone hears 'like-kind exchanges,"' he says. "I don't think anyone has a thorough understanding of what that is or how it works."
Under 1031, real estate must be exchanged for real estate, a rule that sometimes trips up clients who have set up a single entity to hold property and shield themselves from liability. Often, Abrams recommends that clients liquidate the entity a day before the real-estate transaction so the swap qualifies for 1031 treatment.
Apart from problems with the like-kind exchanges, there are other common mistakes that amateur investors make in other real-estate deals. One is not holding the property long enough. You must keep the investment for more than a year before selling to qualify for the preferential 15 percent capital-gains tax rate. If you sell before a year, the gain is subject to the highest income-tax rate of 35 percent.
You can avoid the capital-gains tax if you own and use the home as your primary residence for two years. Gains of up to $250,000 for an individual and $500,000 for a married couple filing jointly are excluded. The two years doesn't necessarily have to be continuous, as long as you've used it as a primary residence for a total of two years within a five-year period, ending on the date you sell the property.