When it comes to property investment, house flipping is undeniably a popular and profitable venture. As enticing as it may be, though, it’s important to tread with great caution, especially concerning the taxation aspect of the process. As those who have dipped their toes in the house flipping pool have found, the tax implications can be rather complex and demanding, potentially resulting in substantial financial burdens if not properly managed.
## Understanding House Flipping and Its Tax Implications
House flipping is essentially the process of acquiring a property at a relatively low cost, improving it, and then selling it at a profit. Investors achieve this practice in a variety of ways: some purchase homes facing foreclosure, others take advantage of lower property market prices, and some even inherit properties that they decide to flip.
Now, while this sounds simple and highly lucrative, one must consider the impact of tax obligations; it’s a crucial aspect that house flippers often overlook. The critical thing to remember is, just like with any other venture, the profits generated from house flipping are not exempt from tax. As such, before you embark on your flipping journey, you must comprehend the complex ramifications of taxes applied on house flipping.
## The Different Types of Taxes Relevant to House Flippers
### Income Taxes
Income tax applies to the profits you make from the sale of a flipped house. The amount of tax you’ll need to account for depends on whether the Internal Revenue Services (IRS) categorizes your profits as ordinary income or capital gains.
Ordinary income refers to the money you make from your regular employment or business, whereas capital gains arise from the sale of an investment or real estate property that you’ve held for a particular duration. You’ll be likely classified as a dealer if you’re a frequent flipper, meaning your profits will be considered as ordinary income.
One thing worth noting is that if the house flipping activities are designated as your primary occupation, the income is taxed at specific rates ranging from 10% to 37%, based on the amount of taxable income for individuals.
On the other hand, if your house flipping is classified as an investment activity, you’re considered an investor and your profits as capital gains. For these, there are two sub-categories: short-term and long-term capital gains.
Short-term capital gain applies if you’ve held the property for less than a year. The taxes payable are similar to that of your ordinary income tax rate. However, Long-term capital gains apply when you’ve held the property for over a year and are generally taxed at more favorable rates.
### Self-Employment Taxes
A considerable downside for dealers is that their profits are subject to self-employment taxes, which encompass Medicare and Social Security taxes. Both total about 15.3 % of your income, commonly with certain restrictions based on income. However, suppose you’re classified as an investor. In that case, your profits from flipping are spared from the self-employment tax, yet another reason many flippers favor long-term investments over short ones.
### Property Taxes
Regardless of whether you’re flipping houses as a business or investment activity, you can’t evade property taxes. The rates differ significantly among various locales since they are imposed at the local level. Always remember to include them when estimating the costs of your flip project.
### Depreciation Recapture Taxes
Depreciation refers to the gradual reduction in the value of an asset over time. The IRS allows property owners to deduct their property’s depreciating value over a period of 27.5 years. Before you get excited, though, realize this isn’t available for flippers — it only applies to rental property owners.
However, when you sell a featured property, you may have to pay depreciation recapture taxes if the sale price is higher than the depreciated value of the property. The maximum tax rate for depreciation recapture is 25% for real estate.
## How to Minimize Tax Burden When Flipping Houses
Fortunately, there are a few strategies that you can implement to reduce your tax burdens while flipping houses.
### Hold onto the Property for More Than a Year
As previously mentioned, the tax rates for long-term capital gains are much friendlier than those for short-term ones. Therefore, if possible, holding the property for over a year could dramatically decrease the amount of tax you owe the IRS.
### Operate in the Form of a Limited Liability Company (LLC)
Forming an LLC might help you save some money in taxes. With an LLC, you can choose how you want the IRS to tax your business. It allows you more options and, as a result, the possibility of selecting the most tax-efficient method for your situation.
### Use a 1031 Exchange
Named after section 1031 of the U.S. Internal Revenue Code, a 1031 exchange allows investors to defer paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property. This approach allows your investment to continue to grow tax-deferred. There’s no limit on how many times you can do a 1031. You can roll over the gains from one piece of property to another to another. Although you may have a profit on each swap, you avoid tax until you sell for cash many years later, hopefully paying only one tax, and that at a long-term capital gains rate.
Despite all the intricacies and challenges posed by the different kinds of taxes on house flipping, the venture is still a rewarding investment strategy when handled correctly. A deep understanding of tax laws and smart planning is crucial for any real estate investor. However, it’s always safe and wise to consult with a real estate tax professional to ensure you fulfill all your tax obligations and exploit every viable opportunity for tax savings.
In conclusion, taxes on house flipping play a significant role in the profitability of your investment. As such, be sure to seek legal counsel and take necessary precautions before embarking on the journey. Though the path to becoming a successful real estate investor can be complex, with careful planning, a robust understanding of tax implications, and a dash of patience, house flipping can prove immensely rewarding.
