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Flipping houses can be a profitable venture, but it’s important to separate reality from the glamorized portrayals on TV. Success in house flipping requires experience, sufficient funding and a solid understanding of the process, especially when it comes to navigating taxes. Let’s take a closer look at what you need to know about taxation when you flip houses for sale.
For personalized guidance, a financial advisor can help you develop a comprehensive financial strategy for your real estate investments.
Are You a Real Estate Investor or Dealer?
The first question you need to answer when discussing house flipping and taxes whether you’re a real estate investor or dealer. The IRS treats each one differently for tax purposes:
- Investors buy and hold property with the expectation that it will appreciate in value. They may use the property to generate rental income. When investors sell property at a profit, capital gains and other tax rules may apply.
- Dealers, on the other hand, are your traditional house flippers. Their whole reason behind buying the property is for resale. Dealers pay ordinary income tax and may owe self employment tax on profits realized from flipping houses.
Here are some points that the IRS will look for to determine if you’re a dealer:
- The frequency and amount of real estate purchases and sales
- Whether and how the property was used, including whether it was used as a primary residence
- Why the property was held and whether it served purposes other than for resale
- How much advertising and promotion went into property sales
- How many improvements were made
- The general activities of the taxpayer selling the property
Flipping a single house does not necessarily make you a real estate dealer. The IRS generally considers the facts and circumstances, including whether your activity shows a pattern of buying properties primarily for resale.
If you’re classified as a dealer, properties held primarily for sale are generally treated as inventory rather than capital assets. Profits from their sale are therefore taxed as ordinary business income rather than capital gains, regardless of how long you hold the property. For additional questions, you could contact a financial advisor or tax expert.
Full Tax Treatment for Real Estate Dealers
Along with paying ordinary income tax rates on profits from the sale, which can go as high as 37%, real estate dealers may also owe self-employment tax. The amount depends on factors such as entity structure, the Social Security wage base and other circumstances. You’re generally considered to be self-employed if you:
- Carry on a trade or business as a sole proprietor or independent contractor
- Are a member of a partnership that carries on a trade or business
- Are otherwise in business for yourself
House flipping may fall into the self employed category when your activity rises to the level of a trade or business. Whether it does depends on the facts and circumstances rather than simply whether house flipping is your main source of income.
For a house flipper operating as a sole proprietor, net business profit generally flows through to the owner’s individual income tax return and may be subject to both federal income tax and self employment tax. The actual tax bill depends on factors such as filing status, other income, deductions and the amount of earnings subject to Social Security and Medicare taxes.
Of course, this is without accounting for additional tax deductions or credits. Deductions reduce your taxable income, while credits shrink your tax liability on a dollar for dollar basis.
Lowering Your House Flipping Tax Burden
Even with the high taxes of being a real estate dealer, there are several ways to lower your house flipping tax burden. Here are two areas to consider when managing taxes for a house flipping business.
1. Consider Your Business Structure
Choosing a business structure is an important part of setting up a house flipping business. A limited liability company (LLC) can provide limited liability protection by helping separate business obligations from an owner’s personal assets. However, forming an LLC does not automatically change how the business is taxed or create additional business deductions.
For federal tax purposes, an LLC’s treatment depends on factors such as the number of owners and any tax elections it makes. A single-member LLC is generally a disregarded entity for tax purposes, while a multi-member LLC is generally taxed as a partnership unless it makes a corporate tax election. An LLC may also elect corporate tax treatment.
Eligible business expenses can generally be deducted regardless of whether the business operates as an LLC. Because LLC formation and liability rules vary by state, owners may want to consider both legal and tax factors when choosing a structure.
2. Make Tax Deductions
If you have business expenses as a house flipper, some may be immediately deductible, while others may need to be capitalized as part of the property’s inventory cost. The treatment depends on the type of expense and the circumstances. Common costs and expenses include:
- Home improvement costs on sold properties
- Interest on real estate loans
- Property taxes on investment properties
- Building permit costs
- Real estate commissions
- Travel expenses
- Office supplies
- All off-site office expenses, like rent, internet, utilities, etc.
- Legal and accounting fees
Keep a paper trail for any expenses you plan to deduct. While IRS audits are relatively rare, there’s never a 0% chance that you won’t be targeted for one. Accurate documentation could help you come through an audit relatively unscathed.
Estimate how deductions and credits could lower your tax bill with our income tax calculator.
Tax Breaks You Won’t Get as a House Flipper
Despite what you may read on the internet, if you’re an active house flipper and are flipping multiple houses a year, there are tax breaks others get that you generally won’t be able to use for properties held primarily for resale. Here are a couple of the tax breaks you may want to consider:
- 121 exclusion: This IRS rule may apply when you sell your main home and meet the applicable eligibility requirements. It lets you avoid capital gains tax on the profit of the sale of your main home, up to $250,000 in profit or up to $500,000 for qualifying married couples filing jointly. In general, you must own and use the home as your main home for at least two of the five years preceding the sale. For the $500,000 exclusion, either spouse must generally meet the ownership test and both spouses must meet the use test. In addition, neither spouse generally can have excluded gain from the sale of another home during the two year period before the sale. That means houses for quick flipping usually aren’t eligible.
- 1031 exchange: This tax deferment program allows investors to sell one investment property and defer the taxes on the sale by buying a new investment property. The IRS gives you 45 days to identify a replacement property and 180 days to make the transaction. But why can’t house flippers take advantage of this? The IRS generally prohibits 1031 tax benefits from extending to properties held primarily for resale.
State and Local Taxes on House Flipping
Federal tax rules get most of the attention, but state and local taxes can hit house flippers just as hard. If you flip in a high-tax state such as California, New Jersey or New York, state income taxes will cut directly into your profits. These rates can run into double digits, meaning a significant portion of your profit is gone before you even account for federal tax.
On top of state income tax, flippers may be responsible for paying:
- Transfer taxes or recording fees each time the property changes hands
- Annual property taxes
- Local licensing or permit fees
Flippers working across state lines face an added layer of complexity. Each state sets its own tax rules, so you may have to file multiple state returns in a single year. Without planning, this can create both higher costs and more administrative work. Understanding the local tax landscape before you buy helps you set realistic expectations about your true profit.
Quarterly Estimated Taxes for House Flippers
If you flip houses as a business, you may need to pay taxes throughout the year instead of waiting until you file your annual return. Because taxes usually are not withheld from house flipping profits, many real estate dealers make quarterly estimated tax payments to the IRS.
Estimated tax payments typically cover both income tax and self employment tax. The amount you owe depends on your expected income, deductions and tax liability for the year. If your income changes significantly from one flip to the next, you may need to adjust your payments as the year progresses.
Failing to pay enough tax during the year can result in underpayment penalties, even if you ultimately pay the full amount when you file your return. Making timely estimated payments can help reduce the risk of penalties and make large tax bills more manageable.
State tax obligations may also apply. Many states with an income tax require estimated payments under rules that are similar to the federal system, although payment schedules and thresholds can differ.
Estimating your tax liability before you buy a property can provide a clearer picture of your potential profit after taxes. Factoring estimated tax payments into your budget may also help you avoid cash flow problems after a sale.
Bottom Line
Buying and selling real estate can be a complex process, especially once you include house flipping taxes. It’s best to go into the business prepared, knowing what you’ll be on the hook for. You need to know what the IRS will require you to pay, along with how to structure your business so that you put yourself in the best position to succeed for the long haul.
Tips for Flipping Houses
- Your house-flipping business doesn’t have to try to manage its finances from growth capital to tax planning on its own. Having a financial advisor in your corner can take a huge weight off your shoulders and provide you with more opportunities to grow. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Along with getting your taxes in order, you should pay attention to where you bank. Some banks are just more friendly to small businesses. Check out our list of the best banks for small businesses to take advantage of these opportunities.
Photo credit: ©iStock/Feverpitched, ©iStock/Svetlana Malysheva, ©iStock/Aleutie