House flipping is a popular real estate investment strategy in which investors purchase properties, usually at a significant discount, fix them up and then resell them for a profit.
While the practice has been around for decades, it only gained popularity recently, particularly in the wake of the housing market crash of 2008, when many homeowners lost their homes to foreclosures—leading lenders to sell for cheap, and investors to buy rundown homes to rehabilitate and sell at profit.
Still, interestingly, house flipping is not just for professional real estate investors. Anyone can be a house flipper with the right knowledge and drive. In fact, many first-time investors have found success in this niche market—we’ve seen it happen.
If you’re thinking about getting into house flipping, there are a few things you need to know about the tax implications of this type of investment. Check them out below.
1. Document Every Expense!
As with any other investment, you must keep good records when flipping houses.
This will help you in two ways:
- Doing so will make it easier to calculate your profits (and taxes owed) when you sell a property.
- It will give you the documentation you need if the IRS audits you. As you can imagine, flipping houses can generate a lot of documentation, so it’s essential to have a sound system for organizing and storing your records.
2. Expenses to Deduct During Tax Time
If you’re flipping houses, there are a ton of expenses you can deduct when it comes to tax time.
There are two main types:
- First, just about everything you spend buying, fixing up and selling the property.
- Secondly, your business expenses, like auto payments, gas, for your auto, computer stuff, marketing the property, even snacks you buy for the contractors!
Say you spend $10,000 repairing and renovating a house that you sell for $50,000. In this case, you can deduct the $10,000 in expenses from your profits, leaving you with a taxable gain of $40,000.
3. You’ll need to pay capital gains tax on your profits.
When you sell an investment property, you must pay capital gains tax on any profits you earn. Capital gains tax is simply a tax on the profit you realize from the sale of an asset. In the case of house flipping, your asset is the property itself.
The good news is that there are ways to minimize your capital gains tax liability.
For example, if you hold the property for more than one year before selling it, you will be eligible for the long-term capital gains tax rate which is generally lower than the rate for short-term gains. Additionally, you can take advantage of certain deductions, such as the costs of improvements made to the property.
4. You may be subject to self-employment tax.
Another issue you can face is if you’re flipping houses as a business venture—then you may be required to pay self-employment tax on your profits. Self-employment tax is essentially Social Security and Medicare tax for the self-employed. The current rate is 15.3% which includes the employer and employee portion of the tax.
However, there are circumstances under which you may not be required to pay self-employment tax.
For example, you may not be subject to this tax if you’re flipping houses as an individual investor (rather than through a business entity). And if your total income (including your flipping profits) is below the self-employment tax threshold ($400 for 2019), you will also be exempt from paying this tax.
Of course, nobody is going to flip a home for a mere $400. But you get the point.
5. You can avoid capital gains tax via a 1031 Exchange.
Let’s suppose you’re looking to reinvest your profits from a house flip into another property. In that case, you can do so without paying any capital gains tax by taking advantage of the 1031 exchange provision. This provision allows investors to defer their taxes by rolling their profits into a new investment property.
For example, if you sell a house for a $50,000 profit, then you can use that money to purchase a new investment property without paying any capital gains tax on the sale.
The negative of doing a 1031 Exchange is that you can’t use any of the funds from the sale to live off of.
6. Other taxes depend on your location.
In addition to federal taxes, you may be subject to state and local taxes on your house flipping profits.
These taxes will vary depending on your location, so it’s important to check with your state and local tax authorities to determine what you’ll owe. For example, in some areas, you may be required to pay transfer taxes when you sell a property.
7. You may be required to pay estimated taxes.
Next up, if you’re flipping houses as a business, you may be required to pay estimated taxes on your profits. Estimated taxes are periodic payments made to the IRS throughout the year, based on your expected tax liability for the year. They’re due yearly on April 15th, June 15th, September 15th, and January 15th.
If you fail to make your estimated tax payments, you may be subject to penalties and interest. Therefore, staying on top of your estimated taxes is crucial if you’re flipping houses as a business.
Uncomplicated Tax, Uncomplicated Profits
We hope this quick overview gave you a better understanding of the tax implications of house flipping.
As with any type of investment, it’s important to do your homework and consult with a tax professional before getting started. But if you’re looking for a lucrative investment opportunity, house flipping may be just what you’re looking for.
Maximize your flipping profits today! Join as a REIA member, attend our upcoming meetings, and sign up for our informative newsletter. We can help you take care of all the details, from repairs and renovations to accounting and taxes.