Many investors fail to plan for the tax consequences of flipping real estate and end up sharing too much profit with an uninvited partner: the IRS.
House flipping is more than buying a home and selling it for a profit. Complicated tax rules govern real estate transactions, and it’s essential to understand the basics to keep as much money as possible in your pocket.
Flipping Houses 101:
6 Tax Consequences
In this flipping houses 101 guide, we’ll explore common tax implications for real estate investors and opportunities to minimize your tax burden.
1. Investor vs. Dealer-Trader
The tax consequences of flipping real estate are partly determined by whether the IRS categorizes the seller as an investor or a dealer-trader who sells property as their full-time business. The specific considerations that shift individual investors into the category of a dealer come down to whether their real estate activity indicates property is treated as inventory. These include:
- The purpose the property was acquired and subsequently held for.
- The extent of improvements made to the property.
- The extent of advertising and promotion of the property for sale.
- Whether the property was listed with a broker.
- The number and frequency of property sales.
- The nature and extent of your business activities.
Dealer status has a number of tax implications, making professional flippers ineligible for depreciation deductions on real estate, 1031 exchanges, installment sales, and the long-term capital gains rate. If you frequently buy and sell properties or derive most of your income from flipping houses, it may be worthwhile to consider a corporate structure for your real estate business to avoid being taxed as a dealer.
2. Capital Gains
A profit generated from the sale of a property is considered a capital gain, which is one of the most significant tax consequences for fix-and-flip investing. Broadly, it’s anything above the purchase price and improvements minus depreciation.
Capital gains taxes vary based on the length of ownership:
- A short-term capital gain applies to properties held for one year or less, and the profits are considered an extension of your annual income. The tax rate for short-term capital gains is generally consistent with the standard income tax rate.
- A long-term capital gain applies to properties held for more than a year. The tax rate for long-term capital gains is 15-20 percent, depending on how much profit you earn.
To reduce your tax burden, remember that you’re only taxed on your net capital gain for a given year. That means if you sell a long-term investment property at a capital loss, you can use it to offset capital gains from a profitable sale, reducing the total amount that can be taxed.
Dealer-traders aren’t allowed to take advantage of long-term capital gains rates when selling properties, regardless of how long they hold the property. Dealers also aren’t eligible to benefit from installment sales or 1031 exchanges.
3. Rollover Provisions
While you can defer taxes on flipping houses by selling one property and immediately reinvesting the sale proceeds into another, that’s only possible under certain circumstances. This tax strategy is known as a like-kind or 1031 exchange and is available to real estate investors but not to dealer-traders.
The parameters for a 1031 exchange are fairly broad. For example, you can exchange a residential rental property for a commercial property as long as the exchanged property is also an income-generating asset. A 1031 exchange can delay taxes until you sell—unless you can sustain a cycle of exchanging into new investment properties.
Both investors and dealer-traders can take advantage of a capital gains exclusion on the sale of a primary residence. To qualify, the IRS requires you to have lived on the property for at least two of the past five years to exclude up to $250,000 in profits from capital gains taxes or up to $500,000 when filing a joint return with a spouse. However, if you are selling a house where you never lived, it’s considered an investment property and isn’t eligible for the Section 121 exclusion.
4. Active vs. Passive Income
The income that dealer-traders generate from fix-and-flip real estate is considered “active income” and subject to ordinary income tax rates in addition to self-employment taxes. The tax treatment of active income differs from passive income, which is income generated from rental properties.
A benefit that is available to dealer-traders is the ability to deduct losses in full in the year of the sale. Investors may be limited in the amount of loss they can claim for a real estate transaction, depending on their other capital gains or losses in a given year.
5. Corporation vs. LLC
The main advantage of forming a business entity for a house-flipping business is to remove personal liability for its success or failure. It can also offer privacy and safeguard assets. From a tax perspective, benefits diverge depending on how the entity is classified.
- Limited liability companies (LLCs) and S corporations are considered flow-through entities, which means that income flows through to the owning members and is taxed as individual income. While this can be beneficial to prevent being taxed twice on the same earnings, it won’t alter the tax status of the business owners.
- C corporations are recognized as separate tax-paying entities and subject to double taxation. They are responsible for corporate income taxes, and profits distributed to shareholders as dividends are then subject to personal income taxes.
When it comes to buying and selling real estate through your business entity, if your LLC is named on the property title, flow-through taxation means the LLC capital gains tax will be consistent with the individual capital gains tax.
6. Deductible Expenses
The IRS allows professional house flippers to claim many business expenses as tax deductions. These are the main categories of eligible expenses:
- Capital expenditures include money spent purchasing a property and making upgrades. However, you can’t deduct capital expenditures from taxes before selling the property they’re associated with.
- Office expenses, such as business cards and office supplies, to conduct business are fully deductible. Operational expenses for an off-site office—including rent, utilities, phone, and internet—are also deductible. For a home office, you may deduct a percentage of the house’s expenses based on the square footage of your office relative to the entire house.
- Vehicle expenses can be claimed for business travel, even if you conduct the travel with a personal vehicle. The IRS has two methods to calculate vehicle expenses. The first is the standard mileage rate, which is the miles traveled for the business multiplied by the standard mileage rate (67 cents per mile in 2024). The second method is deducting actual vehicle expenses, including maintenance, repairs, oil, and fuel. If you claim a vehicle deduction, be prepared to maintain a written log tracking mileage and keep receipts for gas purchases and vehicle repairs.
- Interest payments for fix-and-flip loans are eligible expenses. This simplifies short-term financing to those who provide funding quickly rather than those who offer the best interest rates.
- Miscellaneous expenses such as property taxes on the investment property, building permit costs, real estate commissions, and legal and accounting fees are also expenses you may claim.
The best way to keep track of deductible expenses is to set up a separate checking account for each property. This helps prevent commingling expenses from multiple properties, which could lead to confusion and tax issues.
Fund Your Next House Flip with Socotra
Given the complexities of tax laws governing real estate transactions, plan on recruiting an experienced accountant familiar with real estate investing for your fix-and-flip business. Seeking expert tax advice up front will help ensure maximum tax benefits and minimum payouts for your business. They’ll be able to help you review property sales and related expenses, such as loan fees and interest payments, to capture any eligible write-offs.
If you’re ready to go beyond flipping houses 101, learn how to fund your next property with financing tailored to short-term real estate investments. Read our free resource, The Borrower’s Guide: Fix-and-Flip Hard-Money Loans, for more information.
