Can I Deduct a Loss on a House Flip?

You bought a house with plans to renovate it, sell it and make a profit. Instead, renovation costs climbed, carrying costs added up, the real estate market changed - or all three happened at once. By the time you sold the property, your profitable house flip had become a loss.

Can you deduct the loss?

Potentially. But how much of that loss you can deduct may depend on whether the IRS considers you a real estate investor or a real estate dealer operating a business.

That distinction can make an enormous difference. A loss treated as a capital loss may provide only a limited deduction against ordinary income each year. A qualifying business loss may potentially be deducted as an ordinary loss against other income.

For someone who loses $50,000, $75,000 or more on a renovation project, that's not a minor distinction.

Is Flipping Houses a Business or an Investment?

There isn't a rule that simply says, "If you flip one house, you're an investor; if you flip five houses, you're a business."

Instead, the tax treatment depends heavily on why you acquired the property and what you did with it while you owned it.

An investor generally acquires property to hold for appreciation or income. A real estate dealer, on the other hand, holds property primarily for sale to customers in the ordinary course of a trade or business.

Think about the difference between these two situations:

• You buy a property, rent it for several years, benefit from appreciation and eventually decide to sell it.
• You buy a distressed property specifically to renovate it, work continuously to prepare it for resale and put it on the market as soon as the renovation is finished.

Both people bought real estate and eventually sold it. Their purpose and activity, however, are very different.

Why Dealer vs. Investor Status Matters When You Lose Money

The distinction becomes especially important when a property is sold at a loss.

Property held by a real estate dealer primarily for sale to customers in the ordinary course of business is generally treated as inventory rather than a capital asset. If the activity qualifies as a trade or business, a loss may therefore be an ordinary business loss rather than a capital loss.

For a sole proprietor, that activity would generally be reported on Schedule C.

An investor's loss generally receives capital-loss treatment instead. Capital losses first offset capital gains. When losses exceed gains, an individual generally may deduct only up to $3,000 of the excess capital loss against ordinary income in a year, with the unused loss carried forward.

Consider someone who loses $75,000 on a flip and has no capital gains available to absorb the loss. If the entire amount is treated as a capital loss, using that loss against ordinary income could potentially take many years.

If the $75,000 qualifies as an ordinary business loss, the tax result can be dramatically different.

This is one reason it's important to identify the nature of your real estate activity rather than assuming that every loss involving real estate is treated the same way. Rental and investment properties can involve an entirely different set of limitations. If you own rental real estate, you may also want to read our article on deducting passive losses.

What If This Is Your First House Flip?

This is where the issue gets particularly interesting.

Suppose this is the first property you've ever flipped. You purchased the house intending to renovate and resell it, spent months actively improving it, and listed it for sale as soon as the work was completed.

Does having only one completed sale automatically make you an investor?

No. But it does make the facts especially important.

Courts examining whether real estate was held primarily for sale in a trade or business have considered several factors, including:

• your purpose when you acquired the property;
• your purpose while you held it;
• the frequency and number of property sales;
• the extent of improvements and development;
• your efforts to market and sell the property; and
• the amount of time and effort devoted to the activity.

The frequency and substantiality of sales can be particularly important. Obviously, someone completing a first flip doesn't have a long history of sales to point to.

But every house-flipping business has a first property.

Your Activity During the Renovation Can Matter

Imagine that you purchased a severely outdated house with one purpose: renovate it and sell it.

For the next 10 or 11 months, you're actively involved in the renovation. The property isn't sitting idle waiting for appreciation. You're investing money, managing improvements and working toward getting the property ready for market.

Once it's finished, you immediately list it for sale - even though market conditions aren't as favorable as you hoped.

Those facts look considerably different from purchasing property as a long-term investment and later deciding to sell it.

Substantial renovation and development activity can help demonstrate that the property was being prepared as inventory for resale rather than simply being held while you waited for its value to increase.

Your Existing Business Can Matter Too

The facts may become even stronger if the flip is related to a business you're already operating.

For example, suppose you're already a self-employed real estate professional reporting commissions on Schedule C and decide to expand your activities by purchasing distressed properties, renovating them and reselling them.

Your first flip isn't necessarily an isolated hobby or investment. It may be the first transaction in an expansion of an existing real-estate business.

That doesn't automatically establish dealer status, but it's another fact that should be considered when evaluating the overall activity.

Don't Choose Your Tax Status Based on Whether You Made Money

There's another side to this strategy that house flippers need to understand.

You don't get to be a real estate dealer when you lose money and an investor when you make money.

If your activity is legitimately a house-flipping business, dealer treatment can help tremendously in a loss year. But when your next flip generates a $100,000 profit, that dealer treatment means the profit generally becomes ordinary business income rather than a long-term capital gain.

Dealer property also generally doesn't qualify for certain tax benefits available to qualifying investment property, including Section 1031 like-kind exchange treatment or installment-sale reporting available in some other real-estate transactions.

In other words, dealer status isn't simply a tax deduction you elect when it's convenient. It describes the nature of your business.

Documentation Can Be Critical for a First-Time House Flipper

If you're beginning a house-flipping business, don't wait until an IRS examination to reconstruct what you intended to do.

Create a business record while you're actually conducting the business.

That can include:

• a written business plan describing your intent to acquire, renovate and resell properties;
• separate business banking and accounting records;
• records of renovation expenses;
• logs documenting your time and work on each project;
• records showing when the property was listed for sale;
• marketing records; and
• consistent tax reporting from one project to the next.

Documentation is especially valuable on a first flip because you don't yet have years of previous transactions demonstrating a pattern of buying, renovating and selling homes.

What Happens If Your First House Flip Loses Money?

Don't automatically assume that the loss belongs on your tax return as a capital loss simply because the transaction involved real estate.

And don't automatically assume it's a fully deductible business loss simply because you intended to make money.

The proper treatment depends on the facts surrounding the property and your business activity.

For someone who actively purchased a property for resale, substantially renovated it, marketed it promptly and intended to continue flipping houses, there may be a legitimate argument that the property was held as part of a real estate trade or business - even if it was the first completed project.

That's an important determination to make before filing the tax return, because the difference between an ordinary business loss and a capital loss can represent thousands of dollars in current tax savings.

Talk to a Tax Professional Who Understands Small Businesses and Real Estate

Real estate taxation gets complicated quickly because the same property can receive very different tax treatment depending on why you bought it, how you used it and what you intended to do with it.

If you're flipping houses, investing in real estate, operating a real estate business or combining real estate activities with another business, Ken-Mar Tax can help you look at the entire picture before determining how a transaction should be reported.

Don't wait until after a profitable - or unprofitable - flip to start thinking about the tax consequences. Good tax planning begins with understanding how your activity will be classified and keeping the records necessary to support that position.