If you’ve ever seen any shows about fixing and flipping a house on TV, you probably understand it can be a great way to make some significant money.
That said, flipping houses do have some limitations if you don’t know about them. Namely, taxes can cut into your profits if you aren’t prepared.
On the other hand, this guide is for you if you’ve never seen a show but have heard about it and are curious about what flipping houses mean.
In this guide, we’ll examine some common issues with flipping houses, such as;
House flipping is a business model where a person or group buys a home and often a distressed property or an underwater owner puts in some improvements and sells it for a mark-up to maximize profits.
In general, what does it mean to flip a house is defined as a business that purchases a house below market value, puts some money into it, and resells it above market value to make a profit.
Like any business, house flipping will incur a certain amount of taxes depending on whether you purchase and hold the property (long-term) or quickly try to resell (short-term).
If house flipping sounds interesting, keep reading this guide about the various tax consequences of flipping a house to determine if house flipping is a business model right for you.
In general, flipping houses is treated as income for the person or entity that is “flipping” the home.
So the simple answer is no. Flipping houses is not tax-free. If you choose to get involved in flipping homes as a source of income, you need to understand the tax implications of flipping a house.
There are plenty of ways to learn about taxes on flipping a house, and you can Google for a great resource to help educate you about the types of taxes you can expect to pay.
For example, one main difference between people versus entities is the amount of taxes to be paid when flipping homes.
In general, corporations pay less than individuals in taxes, so to avoid paying massive amounts in taxes on the income of flipping properties, the best practice is to sell as a legal entity like a limited liability company (LLC) rather than as an individual.
Read Also: Do You Need An LLC To Wholesale Real Estate?
The truth of the matter is that you won’t be able to avoid paying all taxes on flipping a house, but you can significantly reduce the amount you may owe after the sale.
There are a few strategies to lower the tax burden of flipping a house as a business.
First, create a legal entity to handle the income and be taxed at a corporate rate rather than an individual rate.
A second strategy is to hold the property for more than one year. Assets, whether homes or stocks are recognized as capital gains when sold. In other words, the capital gains tax on flipping houses may vary.
The difference between the tax rate of capital gains differs with how long you hold onto the asset. The IRS taxes assets sold for a profit in less than a year at a higher rate than those sold after one year.
Third, the IRS allows for the proceeds from real estate sales to be transferred onto the next property under the 1031 exchange. A 1031 exchange is an exemption that allows a person or entity to transfer their profits from a home sale onto a property of more excellent value.
The amount of taxes on flipping houses will vary depending on certain factors. Lowering your taxes is part of the design of your real estate flipping business.
As with any business, you need to understand the tax implications of flipping a house to be successful. How much taxes you pay on flipping a house depends on a few factors.
Flipping a house is seen as income to the IRS, the type of income may vary and could even be categorized as capital gains.
First, to determine the possible tax impact you may face, let’s discuss profitability.
As a general rule, the 70% rule for flipping houses will help you determine your profitability while also anticipating your tax strategy.
If you’re curious as to what is the 70% rule in house flipping, it’s a simple calculation of what you should expect to invest and costs to determine your potential rate of return.
Simply, it is a calculation that goes like this;
As you determine your profitability on the house flip, it informs your tax strategy's next phase.
You can choose to sell quickly and less than a year, which is known as short-term capital gains, or you can choose to sell after a year, known as long-term capital gains.
There is a stark difference in the amount of taxes paid on short-term and long-term capital gains. Therefore, your profitability expectations should inform your tax strategy depending on market trends.
With short-term capital gains, you are taxed at your standard income rate. However, with long-term capital gains, your tax rate is lower.
House flipping can be an attractive business opportunity if there is a strategy to handle all the expenses, which includes having a specific tax strategy.
Understanding what it’s like to flip a house requires you to understand market trends, repair and construction costs, and the types of taxes you can expect.
In general, taxes on flipping a house are considered income for your business. However, the rate of taxes varies on how long it takes you to turn the purchased property into a sale.
For less than a year, the taxes mirror your regular income tax rates, while after one year, the rates are seen as long-term capital gains and are paid at a lower rate.
So, short-term (less than one year) is seen as ordinary income for the business. Long-term (more than twelve months) is seen as capital gains and is paid at a much lower rate than regular income.
Before we delve into those deductions and legal entities, we need to answer whether a license is required or can I buy and sell houses without a license?
You can buy and flip properties without a license, but that strategy may increase your possible tax obligations. On the other hand, by establishing your business as a legal entity, you may open your business up to more significant tax deductions.
Types of deductions you may take that are positive tax strategies for renovating and flipping houses include:
Navigating all the deductions and how to report flipping a house on tax returns is a subject matter best left to a tax expert. You may even be able to deduct their services as a business expense!
Be sure to ask your CPA or tax professional first about any tax advice.
Do you pay taxes on flipping houses? In short, the answer is yes.
Flipping houses is subject to self-employment tax rates of 15.3%. However, creative tax solutions can help ease the burden of self-employment taxes.
If you are a sole proprietor in your business, you pay the SE tax rate as established by the IRS. However, if you elect to be a legal tax entity such as an LLC, you can choose to pay yourself a reasonable salary and claim disbursements on the remainder of your profits.
It works like this: You establish an LLC for tax purposes of your house flipping business and choose to pay out as an S-Corp. This designation allows you to pay yourself a reasonable salary from your profits and then pay out the remainder as disbursements, lowering your self-employment tax burden.
One caveat to this strategy is that the IRS expects the amount of self-employment salary to be reasonable. You can’t just claim 1 dollar as your salary, in other words.
The 121 exclusion is a provision in the tax code that allows for homeownership deductions up to $250,000.
To qualify, homeowners must possess and live in the property for 2-years within a 5-year window, meaning you can rent your home for up to 3-years, live and use the house, and claim up to $250,000 as exemptions.
Combined with long-term capital gains rates, this exemption can make long-term flipping an excellent investment opportunity and lower the overall taxes for house flippers as a result.
There are built-in advantages to homeownership in the tax code, from holding and occupying the home for up to 2-years in a 5-year window (the 121 exclusion).
You may also exchange the profits of one home sale toward purchasing a more expensive prived home (a 1031 exchange) and lower the tax implications from ordinary income to long-term capital gains rates.
That said, taxes on house flipping is calculated by a few different factors.
First, is the home occupied by the owner, and if so, for how long?
Second, is the home held for less than a year or more?
Finally, if the home is sold in under a year, it is seen as regular income, which means there are added taxes such as FICA, state and local taxes, and property taxes on the property.
As with any business, knowing how to maximize your deductions is part of the overall business strategy to achieve profitability.
House flipping for profit is a great investment tool and business opportunity with plenty of tax advantages.
To flip houses at maximum profitability, you need to take into account all the various factors that may affect your margins, from market trends, labor, material costs, and tax implications.
Our wholesale real estate course is designed to help you become the real estate investor you wish to be to learn more about the advantages of flipping real estate and all the tax implications associated with it.
The opportunities to enrich yourself and your family through real estate are right here, and the cost of inaction is real. So, get started today!
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