Flipping houses can be a lucrative business. But don’t let the idealized house-flipping TV shows affect your view of how it works. You need to be experienced, funded and knowledgeable about what you’re doing. That’s especially true when it comes to flipping houses and taxes. Thisreal estate guide breaks down what to expect with house flipping taxes. A financial advisor can help you create a financial plan for your real estate investment goals and help protect your business from financial mistakes.
Are You a Real Estate Investor or Dealer?
The first question you need to answer is whether you’re a real estate investor or dealer. The reason is that the IRS taxes these two classes differently. An investor typically buys and holds property for a minimum of a year. Usually, investors are using the property for rental income and as an asset, they expect to increase in value slowly over many years.
Dealers, on the other hand, are your traditional house flippers. Their whole reason behind buying the property is for resale.Here are some points that the IRS will look for to determine if you’re a dealer:
- The frequency and amount of real estate purchases and sales
- Whether the property was ever listed as your primary residence
- Why the property was held and whether it served other purposes than for resale
- How much advertising and promotion went into property sales
- How many improvements were made
- The general activities of the taxpayer selling the property
In general, if you’re flipping a house, you’re buying it with the sole purpose of improving it and reselling it. This makes you a real estate dealer. If you have any further questions, you should contact a financial advisor or tax expert.
Flipping Houses and Capital Gains Tax
There are two types of capital gains taxes,short-term and long-term. Short-term capital gains taxes are taxed at the same rate as your income tax and are for profits on assets (like real estate) that were held for less than a year. Long-term capital gains taxes are for assets held over a year and are charged at a more favorable rate, ranging from 0% – 20% depending on the bracket.
House flippers are mostly going to fall into the camp of short-term capital gains. Remember, when you’re flipping a house, every day you’re holding onto the property, you’re losing money. You want to get in, make improvements and sell at a profit quickly. That’s especially true if you funded the purchase with a loan.
Full Tax Treatment for Real Estate Dealers
At this point, we’ve established that active house flippers are real estate dealers. That means there are other taxes they need to be aware of. Along with paying personal income tax (which can go as high as 37%), real estate dealers will need to pay an additional 15.3% self-employment tax.
Let’s work through an example using SmartAsset’s tax calculator. If a real estate dealer filing separately receives $200,000 in income for the year, they can expect to pay$40,811 in federal income taxes. Add to that $30,600 for self-employment tax and you’ve got a total tax bill of $71,411 or 35.71% of $200,000.
Of course, this is without accounting for tax deductions. Let’s talk about some steps to lowering your tax bill.
Lowering Your House Flipping Tax Burden
Even with the high taxes of being a real estate dealer, there are ways to lower your house flipping tax burden. Here are three steps to take to help lower your tax bill as you start flipping houses.
1. Form an LLC
Before you get into house flipping, it’s smart to set your business up. One of the most popular business structures is a limited liability company or LLC. LLCs allow you to make deductions for business expenses. On top of that, they help you protect your personal assets against a legal claim if things go awry.
Their flexibility is another reason why they’re so popular. An LLC can be a sole proprietorship or partnership or be organized as a corporation to take advantage of applicable tax benefits. Keep in mind that LLCs are state-governed entities, so the exact rules on forming them and the benefits they provide vary by state.
2. Make Tax Deductions
As an LLC, you can write off many of your house-flipping business expenses. Here are nine common deductions you may be able to make:
- Home improvement costs on sold properties
- Interest on real estate loans
- Property taxes on investment properties
- Building permit costs
- Real estate commissions
- Travel expenses
- Office supplies
- All off-site office expenses, like rent, internet, utilities, etc.
- Legal and accounting fees
3. Deduct Capital Losses
You may not profit every time as a house flipper. The upshot to that is that you can deduct any capital losses you face and use them to offset your capital gains tax. Talk with your financial advisor about how best to offset these gains with losses and whether you qualify for capital loss carryover.
Tax Breaks You Won’t Get as a House Flipper
Despite what you may read on the internet, if you’re an active house flipper flipping multiple houses a year, there are tax breaks others get that you won’t. Here are a couple of the tax breaks you may want to consider:
- 121 exclusion:ThisIRS rule applies to your primary residence. It lets you avoid capital gains tax on the profit of the sale of your primary residence, up to $250,000 profit (or $500,000 if married). To reiterate, this house must be listed as your primary residence to qualify. The exclusion requires you to have lived in the home for at least 24 of the previous 60 months. That means houses for quick flipping don’t qualify.
- 1031 exchange:This tax deferment program allows investors to sell one investment property and defer the taxes on the sale by buying a new investment property. The IRS gives you 45 days to identify a replacement property and 180 days to make the transaction. But why can’t house flippers take advantage of this? The IRS is very particular about who can participate in a 1031 Exchange. They specifically bar property bought for resale from participating.
The Bottom Line
Buying and selling real estate can be a complex process, especially once you include house flipping taxes. It’s best to go into the business prepared and know what you’ll be on the hook for. You need to know what the IRS will require you to pay, along with how to structure your business so that you put yourself in the best position to succeed for the long haul.
Tips for Flipping Houses
- Your house-flipping business doesn’t have to try to manage its finances from growth capital to tax planning on its own. Having a financial advisor in your corner can take a huge weight off your shoulders and provide you with more opportunities to grow. If you don’t have a financial advisor, finding one doesn’t have to be hard.SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals,get started now.
- Along with getting your taxes in order, you should pay attention to where you bank. Some banks are just more friendly to small businesses. Check out our list of thebest banks for small businessesto take advantage of these opportunities.
Photo credit:©iStock/Feverpitched,©iStock/Svetlana Malysheva,©iStock/Aleutie
As a seasoned real estate investor and financial advisor, I've navigated the intricate landscape of property investments, specifically in the domain of flipping houses. My expertise stems from years of practical experience in buying, renovating, and reselling properties, coupled with an in-depth understanding of the tax implications and financial strategies involved in this business.
The process of flipping houses involves intricate knowledge not only of the real estate market but also of tax regulations, as highlighted in the article. Let's break down the concepts mentioned:
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Real Estate Investor vs. Dealer: The IRS distinguishes between real estate investors and dealers based on their intent and activity in property transactions. Investors typically hold properties for rental income or long-term appreciation, while dealers, such as house flippers, purchase properties specifically for resale.
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Capital Gains Tax: Flipping houses often leads to short-term capital gains taxation, wherein profits from properties held for less than a year are taxed at regular income tax rates. Long-term capital gains, applicable for assets held over a year, have more favorable tax rates.
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Tax Treatment for Real Estate Dealers: House flippers, categorized as dealers, are subject to personal income tax as well as a 15.3% self-employment tax. The combined tax rates can significantly impact the overall income from the flipping business.
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Strategies to Lower Tax Burden: Several strategies exist to mitigate the tax burden for house flippers. These include forming a Limited Liability Company (LLC), leveraging tax deductions for business expenses related to house flipping, and deducting capital losses to offset gains.
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Exclusions and Restrictions for House Flippers: Despite various tax breaks available for real estate, active house flippers might not qualify for certain advantages like the 121 exclusion (capital gains exemption on primary residence) or the 1031 exchange (property exchange for investment purposes).
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Financial Advisor's Role: Engaging a financial advisor can be pivotal for house flippers to manage finances effectively, plan taxes, structure their business, and make informed decisions.
This comprehensive understanding emphasizes the critical need for house flippers to be well-versed in tax laws, employ strategic financial planning, and potentially seek expert advice to optimize their business operations and minimize tax liabilities.
