Too many house flippers fail to plan for the tax consequences of their transactions and end up sharing too much profit with an uninvited partner – the IRS. House-flipping is governed by complicated tax rules. Here are six most common tax questions encountered when flipping real estate.
1) Investor versus Dealer-Trader
The tax treatment of flipped houses is partly determined by whether the IRS categorizes the seller as a real estate investor or a dealer-trader, who flips houses as a full-time business. There is no hard rule for differentiating between occasional flippers and flipping pros. However, if you frequently buy and sell homes, are a real estate broker, own multiple properties at the same time or derive most of your income from flipping, the IRS is likely to consider you a dealer-trader and tax your profits accordingly.
2) Capital Gains
The profit an investor generates from the sale of a property is considered a capital gain. The amount of capital gains tax paid depends on how long the property was held. The sale of a property held for one year or less triggers a short-term capital gain, which is taxed at the ordinary income tax rate. If a property is held for more than a year, the profit from its sale qualifies as a long-term capital gain. The tax rate on long-term capital gains is 15-20%.
Investors can reduce their tax rate by selling a money-making property during the same year that a loss is taken on another long-term property. The loss on the losing property may be used to offset gains from the profitable property.
Dealer-traders are not allowed to take advantage of long-term capital gains rates when selling properties, regardless of how long the property was held. Dealer-traders are also not eligible to benefit from installment sales or 1031 Exchanges.
3) Rollover Provisions
Many fix-and-flippers think taxes can be deferred by selling one property and immediately reinvesting the sale proceeds in another, but that is possible only under certain circumstances. This tax strategy is available to real estate investors, but not to dealer-traders. Exchanging one property for another similar property is known as a like-kind or 1031 Exchange. The parameters for a 1041 Exchange are fairly broad. A residential rental property can be exchanged for a commercial property, for example, as long as the exchanged property is also an income-generating asset. While a 1031 Exchange can delay taxes, the tax bill comes due when the investment property is sold.
Both investors and dealer-traders can take advantage of an IRS provision that allows the tax-free sale of a property that has been your primary residence. To qualify, you must have lived in the property for at least two of the past five years. If this provision is met, you may be able to exclude up to $250,000 of the sale profits from taxes. However, if you are selling a house where you never lived, the property is considered an investment property, which has entirely different tax considerations.
4) Active versus Passive Income
The income that dealer-traders generate from house flipping is considered “active income” and subject to ordinary income tax rates, plus another 15% for 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 deducting losses in full in the year of the sale. Investors may be limited in the amount of losses they recognize on a real estate transaction in a given year, depending upon their other capital gains or losses during that year.
5) Corporation versus LLC
The main advantage of incorporating a fix-and-flip business is separating business activities from your private life and eliminating any personal liability for the success or failure of the business. Incorporating does not alter the tax status of the business owner and may actually signal to the IRS that you are a dealer-trader.
6) Deductible Expenses
The IRS allows professional house flippers to write off many of their business expenses. The money spent purchasing a property and making upgrades is considered a capital expenditure, which may be deducted from taxable income after the property’s sale. However, these expenses cannot be deducted prior to the sale.
Office expenses may be deducted, whether the flipper works out of a home office or an off-site office. All office expenses for an offsite office, including rent, utilities, phone and Internet, are deductible. For a home office, a percentage of the house expenses, based on the square footage of your office relative to the entire house, may be deducted. Other direct business expenses such as office supplies and business cards are fully deductible.
Flippers who use their personal vehicle for business travel may also claim travel expenses as a deduction for the business. The IRS allows two methods for calculating vehicle expenses. The first is the standard mileage rate, which is miles traveled for the business multiplied by the standard mileage rate (54 cents a mile in 2016). 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.
A variety of miscellaneous expenses related to the business may also be claimed such as property taxes on the investment property, building permit costs, real estate commissions and legal and accounting fees
The best way to track deductible expenses is to set up a separate checking account for each property. This avoids commingling expenses from multiple properties which may lead to confusion and tax issues.
Given the complexities of tax laws governing real estate transactions, house flipping start-up businesses should plan on recruiting an experienced accountant to the team who is familiar with real estate investing. Seeking expert tax advice upfront will help ensure maximum tax benefits and minimum payouts for your business.