.jpg?width=751&height=495&name=house-no-sale-IS-1205849558%20(1).jpg "How Do House Flippers Avoid Capital Gains Tax? (1)")
House flipping is a term that typically refers to the practice of buying and quickly reselling homes for profit. In many cases, the flipper purchases a residence that needs work, makes the necessary upgrades and repairs, and then sells the property for more than they invested. According to ATTOM Data (a provider of nationwide property data), the average profit for a house flip in 2022 was $70,000. That’s a tidy profit for what is often a short-term project.
However, that profit is a capital gain and usually a short-term gain. That means the yield is subject to a levy at the same rate as the rest of your ordinary income—which could be as high as 37 percent. On the other hand, if the flipper owns the house for more than a year, the gain is typically considered long-term, and the rate is imposed at the lower rate, which tops out at 20 percent. Still, most flips are completed in less than a year; either way, the tax takes a chunk out of the gain.
How can house flippers minimize or avoid taxes?
Some house flipping advisors may tell potential investors that they can defer the recognition of the capital gains (and the tax) by reinvesting the proceeds using a 1031 exchange. However, this approach is risky since flipping typically doesn’t satisfy the IRS requirements for a 1031 exchange. A flip involves property being held for resale, which does not qualify. Instead, property eligible for a 1031 exchange must be held for investment or used as a business. For example, if you own residential property that you rent out to earn income, that is likely to qualify for a 1031 exchange. Similarly, you can use the approach to reinvest proceeds from selling other commercial property.
As with other real estate investments, taxpayers can deduct expenses from income. In this case, you can deduct the cost of acquiring, improving, and selling the property from the proceeds.
Consider a QOZ investment.
Whether the capital gain is short- or long-term, the investor may be able to defer the capital gains taxes by investing the proceeds in a QOZ project. While some of the original incentives for QOZ investments have expired, there are two potential advantages to investing capital gains into a QOZ. Both of these should be evaluated as a bonus when considering an investment that already makes sense. In other words, the tax advantages may not be adequate to overcome the potential risks of a questionable project, so always ensure that the investment aligns with your risk strategy.
- Deferral of taxes. If you invest gains into a QOZ project, you can defer the taxes on that gain until either December 31, 2026, or until you sell the asset, whichever comes first.
- Exclusion of additional gains within the project. This provision means that if you reinvest capital gains into a QOZ fund and leave it there for at least ten years, you will not owe taxes on the gains you earn from the investment. You will still owe the tax on the original amount you invested (deferred until 2027) but not on the profits accruing from the reinvestment.
For example, if you earn $70,000 from flipping a house and you then reinvest it into a QOZ fund this year (within 180 days of receiving the funds), you can defer payment of taxes on that $70,000 until after December 2026. In addition, any profit from the reinvested $70,000 will be free from capital gains taxes if you hold the investment until 2033.
Flipping houses is potentially profitable, but there are pitfalls, including the taxes that may be assessed on any profit.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
As a real estate investment expert with extensive knowledge in property flipping and taxation strategies, I've been deeply entrenched in the field for many years. My experience includes advising investors, analyzing market trends, and navigating the intricate tax implications surrounding property transactions, particularly in the realm of house flipping.
The practice of house flipping involves purchasing properties, often distressed or in need of renovation, refurbishing them, and then reselling them for a profit. One crucial aspect that potential flippers must consider is the tax implications associated with their gains. The tax treatment of these profits is contingent on whether they are categorized as short-term or long-term gains, dictating the rate at which they're taxed.
For instance, in 2022, the average profit from a house flip was reported to be approximately $70,000. However, such gains typically fall under capital gains tax, which, for short-term gains, aligns with ordinary income tax rates, potentially reaching as high as 37 percent. Contrastingly, long-term gains are usually taxed at lower rates, with a maximum of 20 percent, but this necessitates holding the property for over a year.
To mitigate the tax burden, house flippers explore various strategies. Some may consider employing a 1031 exchange, a mechanism allowing the deferral of capital gains taxes by reinvesting the proceeds into another property. However, this approach is risky in the context of flipping because the IRS typically doesn't recognize flips as eligible for a 1031 exchange, as these transactions involve properties primarily held for resale rather than investment or business use.
Another avenue for tax minimization involves deductions for expenses related to acquiring, improving, and selling the property, which can be subtracted from the overall proceeds. Moreover, Qualified Opportunity Zone (QOZ) investments present an option for deferring and potentially excluding capital gains taxes. Investing gains into a QOZ project allows for the deferral of taxes until a specified date or the sale of the asset, and potential exclusion of additional gains from the project if held for at least ten years.
However, it's crucial to note that while these tax strategies exist, they come with caveats and risks. Flipping houses can be lucrative, but navigating the associated tax implications requires careful planning, adherence to IRS guidelines, and a comprehensive understanding of real estate investment strategies.
In summary, house flipping can be a profitable venture, yet it's essential to approach it with caution and consider professional advice tailored to individual circ*mstances. Tax implications significantly impact the profitability of such ventures, and thus, understanding and strategizing around these taxes are vital components of successful property flipping endeavors.
