- Hey guys, this is the second part of the video
when it comes to installment sales,
and in this video,
I'm going to discuss the installment sales
as it applies to flipping.
So in my previous video,
I covered what it means for an investor
to sell a property on an installment sale.
Now we're gonna talk about flipping.
Okay, let's get started.
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Okay, so if you wanna flip property,
this is where you get into a different area altogether,
where you can get yourself in serious tax trouble
if you don't know what you're doing,
when it comes to selling property on an installment sale.
I can't tell you how many people who flip property,
will call me up and and say,
"Hey, what can you do for me,
I'm stuck in this situation.
My CPA just told me, I owe the IRS $120,000.
I don't know where that money is coming from
'cause I don't have it.
And I've never received it.
I've sold these properties,
and I haven't brought in that much money.
Are they wrong?
What can we do?"
Well, unfortunately,
for many of those investors or CPAs are 100% correct.
Because when you flip property,
you're what is considered a dealer.
Now I've got other videos on this.
But just to recap what that means.
Okay, a dealer is someone,
it could be an entity or an individual, doesn't matter,
I prefer to you do this through an entity
so you're not treated as a dealer individually,
but it is someone who buys property, real estate
with the intention to sell,
that is you buy it,
and you treat it as inventory.
So people who flip you know, rehab property,
you're gonna fall within that dealer category.
Now, what happens a lot of times
with these individuals who are dealers, they don't realize,
what are some of the negative aspects of being a dealer?
Well, just to refresh your memory,
there's no 1031 exchange treatment available to dealers,
because the homes that you're flipping
are considered to be inventory.
All income is active income.
So everything that you bring in
from the sale of your property,
is gonna be considered active to you, it's not passive,
like it is if you're an investor, it's gonna be active.
The other part about being a dealer,
is that you have no depreciation.
So if you want to depreciate your property,
engage in a cost segue on that real estate,
it's not gonna happen, you don't qualify for that,
because you can't depreciate inventory,
inventory is held in the ordinary course
of your business for resale.
Now, here's the other aspect about being a dealer,
that screws people up
who are selling property on an installment sale.
You do not qualify
for installment sales.
Okay, boom, boom, right there, you don't qualify.
So what does that mean then
if I don't qualify for an installment sale?
It's because individual investors that flip properties,
because they do not understand the context of this,
how it applies to them,
this is where they get into trouble.
So what does this mean, then?
Well, if I'm a dealer in real estate,
and let's assume that you've set up a business entity here,
you've got a corporation set up or an LLC taxed as a Corp,
that's typically what I recommend
if you look at the other videos.
If you're going to be a dealer,
and you're gonna flip property,
you should have a an entity that's set up to be taxed.
I prefer C-Corp, some people use S corporations,
but nevertheless, this is gonna be a core peer
of an LLC or a traditional Corp
and then be treated as a corporate tax purposes.
Now, this year, let's assume that I sold seven properties
on an installment sale.
So I had seven properties sold on installment sales,
and the total value of those properties that I received,
you know, we add up all the sales contracts
of these seven properties,
let's just say it's 1 million bucks.
It's 1 million.
Now, my basis in all of those properties,
that is the money that I spent to buy the property
and the money that I put into the property.
So my tax basis on all of these properties
is $750,000, 750 K.
So what is my expected gain out of these deals,
the sale of these seven properties?
Well, the expected gain
is the difference between your tax basis
and what the sale price is.
So it's going to be $250,000,
is going to be my expected gain,
you know from all the sales of these properties.
Now if you sold them outright,
you get the $250,000, right?
Right into your corporation,
your corporation would have 250K profit, we get that.
I brought in the 250, so I pay tax on it.
But on an installment sale, it's different, right?
Because even though you sold seven properties,
and the total sale price of all those properties
is the million dollars to those seven different homeowners,
you didn't receive that, what did you receive?
Well, you received the down payment.
So let's assume that on each of these properties,
we took down $10,000.
So I received $70,000,
10,000 on each property.
Now I received payments.
Let's assume that all properties were sold in January,
the beginning of the year, just to make it simple.
And each person paid me $1,000 a month, all right?
So that's each house is bringing in $12,000
on an annual basis, so that's $84,000, I brought in,
in payments 84K.
So let's do the math here.
$154,000 is how much I received this year from those buyers.
So if you're looking at this,
how much is your income to the corporation?
Well, a lot of people say,
all right, well, it's $154,000 is what my income is.
No, not, it's not $154,000, okay?
Your income from the sale of these properties
that you have to pay tax on, is the $250,000.
Even though you only received 154,000, of that $1 million,
you have to pay taxes on the full $250,000.
That is the problem
for people who flip on installment sales.
Because you do not qualify
for an installment sale treatment, as a dealer,
all of that income is taxable in the year of the sale,
despite the fact you're not receiving the money,
you still have to pay taxes on it.
This is how people get into trouble.
And in my example,
I assumed all properties were sold in January.
And many times you know, you know the way it's gonna work,
you sell a property in February, April, June,
a couple in October, December, right?
I mean, that's the worst part, you sell them in December,
you bring in $10,000 in that December sale,
and there's a $50,000 in gain on the sale of that property,
you're gonna take that 10,000 you brought in,
you're gonna pay it
right out to the federal government in taxes.
So the issue we run into
when we're selling property on installment sales is,
dealers is that you pay tax on all of your gain
in the year of sale,
despite the fact you didn't receive the money.
In my last video, you hear me talk about investors
where you pay the income taxes over time
as you bring in the money, not as dealers,
you pay taxes when you sell the property.
So what do you wanna look at then if you're doing this?
Or what are some strategies around this?
Can you get out of it?
No, you can't.
Unfortunately, when you're flipping property,
so why do I like to use a C-Corp for people who flip
especially in installment sales?
Because the C-Corp tax at a flat 21%.
So if you're paying tax on $250,000, at 21%,
I mean, it's a lot better than if it was tax down to you.
And let's say you're in a 30% tax bracket, right?
You, you're now saving 9% in taxes by having that money,
which kind of looks like Phantom income
be taxed to the court.
Now, by the way,
when you receive all those funds in the future,
okay, you're not gonna be taxed on it later on,
since you already pay tax on up front.
The only thing you're gonna pay tax on
on an annual basis beyond this,
would be the interest portion of that income as it comes in.
So you pay taxes, you get the interest income coming in.
But the gains, you've already paid the tax on that.
So basically, you step your basis up
to that million dollars in my example.
So what are some things to think about
if you're flipping property on an installment sale?
Number one, I would try to avoid sales
in I would say October through December, if possible.
Try to restructure those more as a lease option
with those tenants.
So you do a three year lease option to buy January,
work some type of creative arrangement with them
to push that income into next year.
Because when you pay the tax,
or when you sell the property in November, December,
if you're a calendar year taxpayer,
you're paying tax on all that income
and you're bringing in very little,
whereas if you sold it in January,
now you have 12 months of at least receiving payments
from your buyer to help cover the taxes
associated with the gains
that come in from that installment sale
that you're forced to pay tax on in year one.
So that's one thing I would look at.
Another thing I would look at with the C-Corp,
is choose a fiscal year end, okay?
So rather than be on a calendar year
and with a with a C corporation,
you can set your tax year up,
so it ends in March or June or September, instead.
Now, why would I look at fiscal year ends?
Let's assume that in your business,
you determine when you map it out these areas,
so most of my property sales take place
within this seven month period maybe or eight month period.
Well, then knowing that,
I would try to position my tax year end,
so I can capture as much of that income
before my tax year is up.
So if most of my sales took place between
let's say, they took place between October and March
All right, we'll find you they took place
most of the sales took place between October and March,
October and June,
then I'm gonna set up my C-Corp with a September year end.
So it so my year end is right before the Corp.
So then I'll get more payments into my company,
through the buyers before my tax year is up
and I have to pay taxes.
So that's always a good strategy to consider.
Another thing to think about is always file extensions,
again, you can have more money coming in
to help cover those tax liabilities.
Now here's a strategy that I wanna share with you
that is a creative, little bit aggressive,
that you may want to consider as well.
So,
rather than I mean, do all of this stuff,
but the other thing you can look at,
is setting up a separate company over here.
Set up this company, typically this one's gonna be an LLC,
and I'm gonna tax it as an escort.
So I'm gonna have a C-Corp here
and gonna a have an S-corp here.
And I'm gonna make this my factoring company.
Okay, so if you're not sure,
you're not familiar with factoring,
what factoring is is that, you have an installment sale,
you have a note, somebody owes you money, right?
That's what we have here,
when you sell your properties to an individual home,
or they owe you money.
And you take that note,
and you sell it to another company.
Company have come up to you and say,
"Listen, I wanna buy your receivables from you."
And so in order to sell them a receivable,
what you're selling them is that income stream.
So if you wrote these notes up five year balloon,
and they're at 5%,
then five years, okay, will actually be higher.
Now let's say they're at 7% interest,
then a company would come to you and say,
what is the total value of those payments,
what is the income coming in off of that,
and it's determined to be $30,000 of income
they're gonna make.
So they'll tell you, I'll tell you what,
I'll buy this deal from you for about 30K,
I'll give you 10K, $10,000.
So you're gonna forego collecting that extra 20,
you're gonna take $10,000 profit upfront
plus your original basis in the note.
So they'll give you what?
The basis that's, the principal plus 10K of the interest,
they'll pay you that.
And then they're gonna take the 20K
and they're gonna collect on that,
they're gonna get paid on that.
Why would you do such a thing?
Well, because then you get your money up front,
you go out and do more deals with those funds.
That's why you're doing it.
So you could look to sell your existing notes
to a note buyer.
And there's lots of people out there that buy notes,
you could look at doing that.
Or you could do to your own company,
you could set up your own note buying company,
where you agree to buy your own notes.
Now, depending on the value of the properties,
this may or may not work for you,
but for some of my clients, what we look at doing is that,
they're selling the installment sales out of their C-Corp,
and then we have this factoring company over here
that comes in and it buys the notes.
So it ends up owning the notes.
Now the reason we're buying the notes is because as follows.
Remember, if I sold a property on an installment sale,
as a dealer, sold this property and my expected gain
in that property is 50K,
and I'm only bringing in $10,000,
well, I don't have enough money
or I barely have enough money to cover my taxes.
So instead of having a tax to me,
all in year one at $50,000,
I'm gonna sell my note to a factoring company that I set up.
And that factoring company is going to pay me 10K.
So now what do I have to recognize in year one?
Not 50,
but 10.
What is my tax liability on $10,000 to the Corp?
2K, I brought in 10K on down payment,
I got enough to cover my taxes plus 8K leftover.
Now what happens the other $40,000 here,
that's still coming in from the note?
Well, that's gonna come into the S corporation
that's a factoring company.
It's gona generate that money,
it's gonna pay taxes on it as it comes in.
You see how we just changed it.
Now we went from a situation where it's immediately taxable
to deferring the taxes by using a separate company.
Now, in order for this to work,
you have to have a arm's length transaction here,
it has to be commercially reasonable to do all of this.
And the reason why you're setting it up,
is because your other business
is providing the much needed cash flow you need over here,
because then you know,
the more money you can pull back out of this deal,
that means you can go out there and buy more property.
So that's why you're selling the note,
it's not to minimize or avoid taxes, okay?
You're doing it because you need the cash flow.
So as a flipper, I give you a couple different ideas now.
If you're going to buy and sell real estate,
you're gonna use the installment sale treatment,
as a dealer in real estate,
then look at using a C corporation,
look at changing your fiscal year end up, okay,
look at when you're selling the properties
to try to get more money up front,
look at trying to defer the sales through a lease option.
And then if those strategies don't work out for you,
also consider setting up a factoring company over here
where you can help fund your deals
through the factoring company,
so that you cut the income down here
and you spread out the income recognition over time.
Guys, it's all about planning,
looking, sitting down with someone like Anderson, my firm
and going through your scenarios
and determining what's gonna work the best for you.
Many times people go out there
and they just set up the entities,
they start doing the business,
and they don't think through
the implications of the activity that they're engaging in,
until the end of the year when the CPA prepares a return,
they say, hey, you owe this much in tax
and you start looking around going
where's the money to pay the tax?
All right, hope you got a lot out of this.
I know I packed a lot into these two videos,
but it's an issue that has been coming up more and more
with individuals and we're getting a lot of comments
and questions about it.
So I wanted to get that information out there
and at the beginning of the year here,
so you can kick it off on the right footing.
All right, take care of thanks for watching.
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