“It’s not what you make that matters – it’s what you keep.” This old business adage is true; you can’t bank on your gross profits, but you sure can bank on your net after taxes. Sadly, though, many use this adage as a justification for operating in a grey area of business, especially in the tax-planning world.
Recently, there have been many TV shows about the profitability of flipping properties. They have become so ubiquitous that even the names of the shows are starting to repeat (just do a quick search and you’ll be surprised). Many of the shows are so well produced and edited that viewers get hooked on the dream of fast-cash property flipping, with the inevitable outcome being an increasing number of people drawn into attempting it on their own.
Of course, on TV, a lot of the boring bits are removed. For instance, have you ever taped, mudded and sanded new drywall? It doesn’t make for compelling TV, except maybe on late-night cable, where the swearing could be kept in.
Some of the boring bits not included in these shows are very important. For example, each of these boring (yet critical) items has an inherent cost attached that is often not factored into the final profit number:
- The underlying investment structure: whether to hold the property in your personal name or in a corporate structure
- The property and liability insurance that must be in place if the property is to be unoccupied for more than 30 days
- The mortgage carrying costs during the holding period until you resell
- The building permits and inspections that must be applied for and adhered to in order to re-sell a safe property
- The income tax implications of these shorter term real estate deals and how they affect the rest of your long-term hold portfolio
Whether new (or veteran) flippers can be successful in making their profit dreams come true is not the issue for this column. What is important is that property flippers do not play games with tax planning and reporting for this type of real estate: whether it’s a document you signed that was incorrect (for instance, saying the property is your principal residence when you know for a fact that it isn’t), incorrectly claiming deductions on your taxes, or a declaration you made to a bank, partner or purchaser. Playing these games may not bite you immediately, but it is much like a great predator that sits there waiting to strike when you least expect it.
Let’s talk about the tax implications.
Making an incorrect or inaccurate claim when you file your taxes
If you have ever made an inaccurate claim or statement on your taxes to try to keep more money than you are legally supposed to, you have dramatically and purposely increased the risk to your overall portfolio – no matter who recommended that you do so.
Why do some people take this chance? Often they have received inaccurate advice, or they believe the risk is minimal. Or, sadly, they believe they are smarter than the average person and can fool anyone.
The risks inherent in playing this game are not minimal, especially when you are misleading the Canada Revenue Agency (CRA): The risks of being caught have dramatically increased. The question is not if you will get caught trying to cheat on your taxes in real estate but when you will be.
Short-term flipping is not a capital gain
Many in the world of flipping properties claim the profits as capital gains, thus reducing their taxes substantially. However, in the majority of cases, these profits are not capital gains as defined by CRA regulations. They are income and are to be taxed as such. Try to explain that in a 30-minute TV show: it’s boring (yet critical).
I have heard all of the justifications for claiming a short-term property flip as a capital gain, but no matter the approach, I always go back to one question: “What was your real intention?”
Moving in and making it your personal residence by putting your toothbrush in for a few nights or sleeping there for a couple of nights does not change your intention for the property. If you intended to buy it, rent it out long term and create actual investment income from it, then you have a chance. However, if your intent was always to make a quick return and your paperwork shows that (for instance: a short-term mortgage, marketing the property before or right after possession or even proof that the rental income could never cover all your expenses and provide you a regular income), then you are clearly in an income transaction and would be advised to claim it that way.
My clear recommendation is not to play these games, ever, no matter how many others are doing it. Strategic investors understand that the risks far outweigh the benefits.
Next time: What to do if you think you have already filed an inaccurate claim