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In recent years, many jurisdictions have begun to include capital gains as ordinary income due to the effects of major events such as Donald Trump’s tax reform and Brexit. Those in favor argue that it is fair for those who invested their money before these changes were made, whereas those opposed feel the change will hurt small business owners.
Flipping houses for a profit is a strategy that some people use to avoid paying capital gains tax. Flipping property to avoid capital gains tax is the process of selling your home and then buying it back in order to sell it again.
The IRS does not consider home flipping to be a passive investment. Flipping homes is defined as “active income,” and earnings are taxed as ordinary income, with rates ranging from 10% to 37%, rather than capital gains, which are taxed at a lower rate of 0% to 20%. Self-employment tax is typically included in real estate flipping taxes.
Capital Gains vs. Ordinary Income When Flipping Houses
If an investor is classified as a “dealer” by the IRS, earnings from property flips are taxed at the investor’s regular income tax rate. The profit is determined by deducting the costs from the ultimate selling price, which includes the buying price. For “active investors” who make active gains, tax rates vary from 10% to 37%.
A real estate dealer, according to the IRS, buys property and sells it to clients “in the usual course of his or her profession or business.” The majority of fix-and-flip investors are considered dealers; they keep their homes for a short period of time and rely on flipping houses for the bulk of their revenue. Even real estate investors who flip homes on occasion are usually classified as dealers and subject to regular income tax rates.
Profits on properties owned for more than 12 months, on the other hand, are usually subject to more advantageous long-term capital gain brackets ranging from 0% to 20%. An investor has the option of renting out the property or living in it. We suggest utilizing accounting software to keep track of fix-and-flip earnings and expenditures.
Consequences of Ordinary Income Taxes When Flipping Houses
The profit from a flip will be taxed at your current ordinary-income rate if you’re classed as a dealer. Ordinary income tax rates now vary from 10% to 37 percent. Furthermore, the profit is subject to self-employment tax (the self-employed person’s equivalent of FICA), which is 15.3%, which is twice what you would pay as a W2 employee.
Depending on your tax rate, the overall tax effect of a flip may vary from as low as 25.3 percent to as high as 52.3 percent for a dealer. Needless to say, you don’t want to think of your earnings as entirely yours—a large portion of them goes to Uncle Sam.
You should utilize accounting software like QuickBooks Online to accomplish this properly. Their program allows you to keep track of how much you spend on suppliers, contractors, interest, and other expenses that may be deducted from your gross earnings.
When Do Capital Gains Taxes Apply to House Flipping?
If you’re lucky enough to escape the dealer definition by making the bulk of your money flipping homes and selling them after a year, the earnings from the sale will be taxed at the lower capital gains rates.
Keep in mind that most flippers are taxed at the regular income tax rate, but we wanted to highlight it since it does happen. Even better, you won’t have to pay self-employment tax if you qualify for capital gains tax relief.
House Flipping Taxes on Short-Term Capital Gains
The profit from a flip is not given preferential consideration if the property is owned for less than 12 months. Whether you’re a dealer or an investor, short-term capital gains are taxed at regular income tax rates. However, you will save money since you will not be subject to the 15.3 percent self-employment tax.
House Flipping Taxes on Long-Term Capital Gains
If you don’t qualify as a dealer and retain property for more than a year, the profit from the flip will be taxed at long-term capital gains rates. For the majority of taxpayers, these rates currently vary from 0% to 20%. It’s a significant savings when compared to the one-two punch of regular income tax rates and self-employment tax.
“Flippers know that if they keep a property for more than a year and then sell it for a profit, they will face long-term capital gains taxes, which are capped at 20%. The less-than-one-year short-term capital gains strategy is to contrast a losing flip against a winning one. This lowers your net capital gains and, as a result, your taxes on them.”
At Your Pace Online’s Brian Murphy, Attorney, Real Estate Broker, and Tax Prep Educator
TurboTax offers standard tax software whether you run a small company and file as a dealer or as an investor. You can import all of your expenditures and submit your taxes online in a matter of minutes. If you have any concerns, you may contact their customer service team. You can also have your return reviewed before filing to ensure that you get the greatest refund possible.
How Are House Flipping Taxes Calculated?
Your fix-and-flip earnings, which are your sales price minus total expenditures and deductions, will be taxed in the end. The profit is determined by deducting the costs from the ultimate selling price, which includes the buying price.
“The active vs passive activity distinction is one of the reasons real estate taxes is so complex. The concept behind flipping a home is to purchase it, fix it up, and then sell it. This denotes that you are a real estate broker. Pretend you’re in the business of purchasing, repairing, and reselling old lawn mowers. It’s a lawn mower company, just as it’s a home-flipping business.”
JBC Wealth Advisors’ Nathan Byers, CPA/PFS
Price of Purchase
The cost of the home is included in the buying price. While you may consider closing costs, points, and other fees to be part of the purchase price, anything beyond the actual purchase of the building should be considered as an expenditure for accounting purposes.
Consider just the purchase price when calculating your profit, not the amount you financed into your profit calculation. When determining profit, the IRS does not take your funding into account. You will, however, be able to deduct interest as an expenditure.
Expenses
Interest on a mortgage and points, loan fees, materials and supplies, labor, closing costs, taxes, professional services, and all marketing expenditures and real estate agent commissions are all expenses not included in the purchase price. This table gives you a fair idea of things to think about.
The IRS is unconcerned with how you pay for an expenditure, just as it is with the purchase price. It’s usually deductible as long as it was a property-related expenditure. For example, if you spend $10,000 for construction supplies on your Lowes credit card, it is considered a renovation cost.
Profit
After all costs, including the buying price, are deducted, the profit is the amount you made on the sale. To guarantee that you deduct all remodeling expenditures, one of the most essential things you can do is maintain meticulous records of your spending. Transaction Profit = Selling Price – Purchase Price – Expenses is the fundamental calculation.
When estimating earnings for IRS reporting, keep in mind that this may not be your real profit. If you have to pay off mortgage debt to finance the purchase and renovations, for example, it depletes your take-home income. This formula may be used to estimate the amount: The investor’s take-home profit is calculated as follows: Selling Price – Mortgage – Expenses.
Taxes on an annual basis
The projected yearly tax burden is then calculated by multiplying your taxable profit by your regular income tax rate. Keep in mind that you may balance profits with losses from other repairs and flips performed the same year.
Taxes on a House Flip as an Example
Let’s go through a simple example to illustrate how flipping homes taxes are calculated. We’ll base our decisions on four assumptions:
- According to IRS rules, the investment is a dealer, therefore the gains will be subject to ordinary income tax.
- In ten months, the property is flipped, exposing it to ordinary income tax.
- The usual tax rate for an investor is 23%.
- The impact of self-employment tax will be considered.
Example of a House Flipping Tax
- This flip has a profit of $26,500.
- Because the investor’s regular tax rate is 23%, the income tax due on the flip is $6,095 ($26,500 x 23%).
- In addition, the profit is subject to a 15.3 percent self-employment tax, for a total of $4,055 ($26,500 x 15.3 percent).
- This increases the total taxes payable on this flip to $10,150.
The investor is left with $16,350 after deducting the $26,500 profit and the amount required to pay taxes. Keep in mind that the $26,500 cannot be considered the investor’s to spend since Uncle Sam requires his share.
How to File and Pay Your Taxes When You’re Flipping Houses
You’ll need to know when to file and how to pay your flipping home taxes after you’ve calculated them. If your home flipping company makes over $1,000 in earnings per year and you’re a single proprietor, part of an LLC, or registered as a S corporation, you need pay quarterly taxes.
You’ll submit your taxes at the end of the year if you haven’t yet generated income or if you qualify for other exemptions. Most home flippers, on the other hand, pay taxes on a quarterly basis. Estimated taxes are due on the 15th of April, the 15th of June, the 15th of September, and the 15th of January each year.
For instance, the money you made flipping homes from January 1 to March 31 is due on April 15th. Your taxes will be payable the following business day if these dates occur on weekends or holidays.
Schedule C: House Flipping
For these anticipated taxes, you’ll need to fill out a Schedule C. A 1040 Profit and Loss Form is another name for this form.
Keeping good tax records
Because expenditures are so crucial in lowering your taxable income and, as a result, the amount of tax you owe, it’s critical to maintain meticulous records of all expenses connected to a flip. Regardless of how small certain expenditures seem to be, they all add up.
Whether you go the do-it-yourself way and create a spreadsheet for your data, utilize real estate investment software, or accounting or bookkeeping software, be sure you keep track of your flips accurately. It will matter come tax time, since every dollar not spent on an expenditure is subject to taxes.
“There are a few things to think about if you’re thinking about becoming a real estate broker. To offset regular income like as salary and company revenue, you may claim an unlimited number of losses. Additional costs connected to dealer operations may also be claimed.”
— Dalmacio Accountancy Corporation’s founder, Noel Dalmacio, CPA, CFP
Taxes on House Flipping: How to Save Money
While avoiding the fundamental concept of flipping as active income is tough, there are certain exceptions that may allow you to flip a property and avoid paying regular income tax. Holding on to an investment for a longer length of time or even having the home as your main abode are examples of this.
When flipping homes, there are four methods to save money on taxes:
1. Keep an investment property for at least a year.
If you fall into the category of being able to pay capital gains tax rather than regular income tax, consider if keeping the property for a year or longer would be beneficial. Remember that you will be liable to long-term capital gains tax rather than short-term capital gains tax if you own the property for a year or longer.
Using the $26,500 profit as an example, you would most likely owe 15 percent or less in long-term capital gains tax if you owned the property long enough. Furthermore, since it is considered an investment rather than active income, you would not be obliged to pay self-employment tax. As a result, your tax liability would be $3,975 or less, rather than nearly $10,000 as in the example above.
2. Before flipping a house, make it your primary residence.
If you’re flipping a single home on the side, think about whether you could live there once the improvements are finished. If you move in, the tax consideration on the ultimate sale will most likely change from active income to capital gains. Furthermore, current tax rules enable you to avoid paying tax on the gain completely if you reside in the home for two of the five years before the sale.
“Under Section 121 of the Internal Revenue Code, a taxpayer may opt to exclude up to $250,000 ($500,000 for married couples filing jointly) of gain on the sale of property used as a ‘principal home.’ The term “main home” refers to a property that has been owned and utilized as the taxpayer’s primary residence for two years or more in the five years before the sale. This sale or exchange gain exclusion is restricted to one every two years. As a consequence, it should be utilized sparingly by multi-property flippers, and only when the flip transaction is anticipated to result in the greatest taxable gain.”
CPA & Attorney Brian J. Thompson, BrianThompsonLaw.com
3. Complete a tax-advantaged exchange for the flip.
A 1031 exchange, often known as a tax-deferred exchange, enables you to transfer profits from one property to another while deferring taxes. To be eligible for this, you must own the property for at least a year (the longer the better in the eyes of the IRS) and rent it to renters. It can’t simply be utilized on quick-turn properties.
4. Claim Tax Deductions for House Flipping
The IRS enables house flippers to deduct some costs associated with buying, remodeling, and selling homes. You may decrease your taxable income by deducting these expenditures. Some costs may be deducted before the property is flipped, while others, such as major expenditures, cannot be deducted until the property is sold.
Deductible Expenses When Flipping a House
When flipping a home, it’s critical to understand what expenditures you may deduct. This will give you a better sense of how much of your income will be taxed, allowing you to budget for tax payments. This, in turn, has an impact on your next flip’s budget.
When flipping a home, you may deduct the following expenses:
- Expenditures on capital (expenses related to buying and renovating a house with the intention to flip). These are subtracted once the property has been flipped.
- Gas and maintenance, as well as a regular mileage rate, are examples of vehicle costs.
- Rent, utilities, and office supplies such as printer ink and paper are all included in office costs.
- Permits for construction
- Mortgage interest
What Factors Affect a Real Estate Flipper’s Dealer Status?
An active company is one that makes a profit through the sale of an item on a regular basis, whether it’s a property, a car, or merchandise. As a result, an investor who flips homes will almost certainly be classed by the IRS as a “dealer” in houses and will be liable to ordinary income tax on the gains.
A fix-and-flip situation Investors who flip a dozen homes each year, retain them for a short length of time, and/or receive the majority of their income from their real estate flipping company are deemed dealers, and their income is taxed at higher ordinary income rates.
This is in contrast to passive investment income from a rental property, which will be taxed at a lower capital gains rate if it is ultimately sold. However, the IRS law isn’t very clear on what counts as active vs passive income, and numerous variables are considered. The number of homes flipped, whether they’re owner-occupied or leased for a period of time before resale, and how long they’re kept are all factors to consider.
If you’re a fix-and-flipper who hasn’t held a property for more than a year, you’ll almost certainly be taxed at your regular income tax rate of 10% to 37%. Determining your taxes category and the rate you owe is complex, and you should consult with a tax expert.
Frequently Asked Questions (FAQs)
In house flipping, what is the 70 Rule?
The 70 rule specifies the maximum amount an investor should spend for a property. An investor should not spend more than 70% of the projected worth of the property after all repairs and renovations, according to the rule, which is a guideline in the business (ARV).
For instance, an investor should pay $115,000 for a house with an ARV of $200,000 and $25,000 in required renovations ($200,000 x 70% = $140,000; $140,000 Minus $25,000 = $115,000).
What Are Some Other House Flipping Tax Breaks?
Consider transportation, a home office, food, and education, such as workshops and books, when calculating your real estate investment costs and deductions. To make things simple, talk to your accountant and utilize an online tracking system like QuickBooks online.
Is it Possible to Flip Houses with No Money?
There are many methods to flip homes with little money, but you’ll need to come up with innovative ways to contribute to the transaction (e.g., if you have building knowledge, contribute with your time and skills, or have a property you can use to cross collateralize for a hard money loan).
Is a License Required to Flip a House?
To flip a home, you usually don’t need a specific state license, but check with your state since it may depend on how your company works. Some states, for example, demand a contractor’s license if you are a developer. In most instances, you’ll need to apply for permissions and perhaps a business license in a timely manner.
Bottom Line
With almost 200,000 home flips in the United States in 2017, it was an 11-year high. Following this, you’ll need to figure out what taxes you’ll have to pay on your home flipping company. Because earnings from home flipping are usually regarded as ordinary income rather than capital gains, they are liable to regular income tax and self-employment tax.
Flipping houses is a process that can be done by anyone and it’s usually done to make money. It can also be done as an investment, which means you’re looking for the difference between the cost of the house and what you’ve made from it. The difference is then reported on your tax return as capital gains or ordinary income depending on how long you owned the house before selling it.
