[ad_1]
Flipping houses can be extraordinarily profitable, which is one of the reasons why it’s a popular real estate investment strategy.
You go in with a competitive bid, invest some funds making repairs and sprucing up the place, and then sell. It’s rewarding, and when done well, it can be extremely lucrative.
And while many people know about the potential expenses and risks that come with the actual acquisition, remodeling, and sale of house flipping, some investors are surprised to learn about the taxes involved.
In this guide, we’ll discuss everything you need to know about house flipping taxes, including what to expect, when you’ll pay, and the types of tax you can expect to incur.
Understanding Tax Implications of House Flipping
Real estate is a capital asset, so profits from home purchases are taxed under capital gains rules when investors purchase a property and do not live in it as their primary residence.
There are two types of capital gains tax: short term and long term.
Short-term capital gains taxes are taxed the same as your income tax rate and are for profits on real estate that are held for under a year.
Long-term capital gains taxes are for assets held over a year and are charged at more favorable rates (which may range from 0% to 20%, depending on the bracket your profit falls into).
If charged a capital gains tax, buyers will typically be experiencing short-term capital gains tax, since flippers are often motivated to flip and sell quickly to maximize profit.
That said, individuals who purchase and remodel real estate for profit on a regular basis—aka house flippers—are classified as “dealers” rather than “investors” by the IRS. Investors typically hold properties for longer, like purchasing a property and renting it out for income for several years.
Because flippers are often considered “dealers” and not “investors,” they often do not pay capital gains taxes. The properties are considered to be inventory.
As a result, profits on the sale of these properties are treated as ordinary income and will be subjected to the self-employment tax, which is 15.3% in 2024.
How to know if I’m a dealer or an investor?
The IRS looks at the following criteria to determine if you’re classified as a dealer or an investor:
- The frequency and amount of real estate purchases and sales, with dealers having more purchases and sales regularly
- Whether the purchase was ever listed as your primary place of residence
- Whether the property was purchased for the purpose of resale
- The amount of advertising that went into the property’s sale
- The extent of improvements made to the property
- The general activities of the individual flipping and selling the property
If you’re unsure what category you may fit into, you can talk to a licensed certified public accountant (CPA) with real estate experience.
Pre-Flip Planning and Tax Strategies
Setting up business structures like an LLC or an S-corp can provide different tax benefits for house flippers.
Starting an LLC, for example, can offer multiple tax options while offering a layer of personal liability protection. They also allow for pass-through taxation, which means that the income is declared on your personal return to avoid the “double taxation” that corporations face.
S-corps are another popular option. There’s a lot more paperwork involved, but they allow you to have “business income,” and you can choose to pay yourself as a W-9 contractor or as a W-2 employee with a salary. If used to regularly flip real estate, profits and losses aren’t treated as capital gains or losses, but as ordinary income.
If deciding between an LLC vs an S-corp structure, some house flippers choose to set up an LLC that elects to be taxed as an S-corp, which can give you the best of both worlds.
When in doubt, talk to a trusted advisor or CPA to help you determine what structure is best for you—ideally before you get started.
During the Flip—Tax Deductions and Credits
Good news for house flippers: You don’t just subtract the purchase price from the sale price and call it a day for taxable income. You can also leverage both tax credits and deductions on house flips that can reduce your overall tax burden.
Capitalized costs and common deductions for house flippers
Common deductions and costs associated with running your business include:
- Expenses from professional services like lawyers, accountants, and consultants
- Office expenses, including a lease and office furniture (or, alternatively, a home office deduction if working from home)
- Costs of software used to manage the business, including invoicing software, contract software, or accounting software
In some cases, the costs to renovate the property may be eligible to serve as business deductions. In many cases, you’ll need to leverage them as capitalized costs, which means that the cost is added to the original value of the property.
These costs may include:
- Renovation costs, including materials and labor
- Interest on loans taken to acquire the property
- Property taxes paid during the time of ownership
- Costs of obtaining permits and inspections
- Cost of utilities, like electricity and water, which are needed to perform work on the home
Keep careful track of every expense you incur, including receipts and purchase orders.
Possible tax credits
Some house flippers may be able to take advantage of tax credits, which is a dollar-for-dollar amount they can claim on their returns to lower the amount of taxes paid.
The most common tax credits flippers may experience are energy-efficient improvements. Examples include:
- Adding owned solar panels to a home
- Adding a heat pump to an air conditioning unit
- Upgrading to more energy-efficient appliances
The Tax Events of a House Flip
The biggest tax events of a house flip are at the point of sale and the 1031 exchange.
Point of sale
When you sell a property you’ve flipped, you’ll need to keep track of the profit and likely pay taxes on it. You only pay taxes on the income when the goods (aka the property) is sold.
With a point of sale, you’ll subtract the original sales price from your resale price. That’s your gross profit, which you’ll declare on your income taxes if capital gains and losses don’t apply to your business. Business deductions will then be calculated and can reduce total tax owed.
1031 exchange
Section 1031 of the Internal Revenue Code allows taxpayers in certain circumstances to defer recognition of capital gains—and its related liability on your federal income tax on the exchange of certain types of property in what’s appropriately called a 1031 exchange.
A 1031 exchange, however, primarily applies to investors, not dealers, meaning the home was held primarily for sale as opposed to a long-term investment.
If you do flip a house and leverage it as a rental property for an extended period of time, however, a 1031 exchange may be an option.
Filing Taxes After a House Flip
When filing taxes after a house flip, there are a few things to keep in mind.
First: You’ll report all income paid in the previous year on your annual return. You may need to file a business and personal return if you’ve incorporated. In the U.S., everyone needs to file a federal return, though many states also require you to pay state income taxes.
When your annual return is filed, you will be expected to pay whatever is owed that hasn’t been paid throughout the year, with the infamous deadline falling on April 15 most years.
You can file your personal return with Form 1040. Business return forms depend on your incorporation structure.
You may also need to pay quarterly estimated payments throughout the year, which you’ll ideally pay through the year to pay self-employment tax. You’ll need to pay if you’re expected to owe $1,000 or more when your return is filed, or $500 or more if you’re a corporation. Quarterly taxes are typically owed on days around the 15th in the following months:
- April
- June
- September
- January
You can pay quarterly estimated payments with Form 1040-ES.
If you must pay capital gains taxes, you’ll typically need to pay that tax after you sell the asset, though it may only become fully due when you file your annual return. You may be required to pay quarterly estimated taxes.
State-Specific Considerations
As discussed, federal taxes apply to all house flippers, but individual states may have their own tax laws, too. It’s important to keep these in mind. Each state may also have their own income requirements.
Connecticut, for example, has a graduated individual tax with ranges from 3% to 6.99%, depending on your income bracket. They also have a 7.5% corporate income tax rate.
States like Florida, New Hampshire, and Wyoming, meanwhile, do not charge personal income taxes. Some of these states do have corporate tax rates, however; Florida has a corporate tax rate of 5.5%.
Leveraging Professional Help
Flipping houses can be complex, and it’s no surprise that taxes on flipping houses can be equally complex. For this reason, we strongly recommend working with an experienced CPA.
A CPA can advise you about the benefits of different incorporation options and ensure that you’re paying all the taxes owed when you need to. And in many cases, CPAs can save you more than what you pay them by finding potential deductions while avoiding penalties.
For best results, we strongly recommend opting for CPAs with real estate investment experience.
Final Thoughts
Taking the time to ensure that you’re paying the right taxes when they’re owed is essential for house flippers. No one wants to find out they owe an extra $10,000 (plus penalties) when April rolls around.
When you’re ready to start flipping houses, make sure you consider how you want your business to operate. That will determine what types of taxes you pay, how much, and when.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
Source link
