The Flipping Financials: Tax Consequences of the Fix-and-Flip
Our recent report What to Fix When Flipping inspired some questions from the real estate investing community, specifically regarding how the IRS taxes house flippers. In this follow-up guide, we’ll provide the top six tax considerations for anyone thinking of getting into the house-flipping business… And, as a bonus, we’ll share some tricks for flipping houses without any of your own money. You down with OPM? Who’s down with OPM?
The Top 6 Tax Consequences for House Flippers
“If you’re not careful with your real estate flips… your investment strategy could produce a sizable payoff for an unintended partner: the Internal Revenue Service,” says Bankrate; however, as Mark Zilbert of Zilbert Realty Group and CondoFlip in Miami explains, “I work with many investors who say, ‘We love to pay taxes, because it means we’re making money.’”
As with any investment or business endeavor, when it comes to fix-and-flips, instead of going in blind you should first ensure you understand how the IRS might treat your earnings.
I. Investor v. Dealer-Trader
While the IRS does not have a hard-and-fast rule for differentiating between investor flippers and professional dealers, if you complete several real estate transactions in less than a year, you can probably expect the federal tax bureau to consider your house flipping a “business” or “trade” — and this means you’ll be paying the standard, higher income tax.
II. Capital Gains
The profit an investor generates from the sale of a property is considered a capital gain.
The sale of a property held for a year or less is considered 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, at a rate of 15% to 20%.
As long as the IRS deems you an investor (see above), you can reduce your tax rate by offsetting the gains from the sale of one money-making property with the sale of another, losing property.
Dealer-traders, on the other hand, are not allowed to take advantage of long-term capital gains rates when selling properties, regardless of how long the property was held. They’re also not eligible to leverage installment sales or 1031 Exchanges.
III. Rollover Provisions
Another tax strategy that is available to real estate investors but not dealer-traders is the 1031 Exchange, whereby, per U.S. Tax Code section 1031, you postpone your tax bill by arranging for a deferred like-kind exchange.
(“This time-honored maneuver is one big reason that some real-estate investors have struck it rich” — MarketWatch.)
Whether you’re an investor or a dealer-trader, you can cut up to $250,000 of a home sale’s profits from your total taxable income, as long as that home is your primary residence. To qualify, you must have lived there for at least two of the past five years.
IV. Active v. Passive Income
The income dealer-traders earn from house flipping is considered active income, subject to standard income tax rates, plus another 15% in self-employment taxes.
Passive income is treated differently.
Per the IRS:
If you own rental real estate, you should be aware of your federal tax responsibilities. All rental income must be reported on your tax return, and in general the associated expenses can be deducted from your rental income.
If you are a cash basis taxpayer, you report rental income on your return for the year you receive it, regardless of when it was earned. As a cash basis taxpayer you generally deduct your rental expenses in the year you pay them. If you use an accrual method, you generally report income when you earn it, rather than when you receive it and you deduct your expenses when you incur them, rather than when you pay them. Most individuals use the cash method of accounting.
At Pioneer Homes, we specialize in finding investors Detroit cash flow rental properties — investments from which you can earn monthly payments, or passive income, generated from the money invested rather than active work performed.
As a rental property owner, you can also take advantage of numerous tax writeoffs (see below).
As a dealer-trader, one benefit that is available to you is the deduction of losses from sales in a given year.
V. LLC v. Sole Proprietorship
All flippers should consider incorporating to protect themselves from risk. Risks from rental property ownership include environmental contamination, fire protection and slip-and-fall liabilities, and forming an LLC can protect you from personal liability if your property is foreclosed upon, suffers investment losses, is the subject of a lawsuit, etc.
It is important to note, however, that incorporating does not alter the tax status of the business owner and can actually signal to the IRS that you are a dealer-trader.
VI. Deductible Expenses
As detailed in our report 11 Tax Deductions Every Real Estate Investor Should Know, the IRS allows real estate investors to take advantage of a variety of tax deductions, based on factors such as:
- Home office
- Furniture and supplies
- Advertising and marketing
- Professional or legal services
- Casualty losses
To successfully track your deductible expenses, establish a separate checking account for each of your properties.
To protect against tax and legal issues, hire a highly recommended accountant with experience advising real estate investors.
BONUS: How to Flip Houses with None of Your Own Money
OPM stands for Other People’s Money, and that’s how you can flip houses without any of your own.
So, where do you find OPM?
The simplest way to invest with no money is to identify a partner who can invest on your behalf. In this arrangement, you do all the house-flipping legwork, your partner provides the financing, and you split the profits (or losses) 50/50.
Note: BiggerPockets recommends remaining legally independent, avoiding establishing a formal partnership.
II. Hard Money Lenders
If you’re just starting out and plan on executing quick fix-and-flip projects, you might want to consider borrowing from a hard money lender. But, beware, these individuals tend to apply a high interest rate and typically charge extra points on top of that. In other words, the longer you carry the loan, the more interest you pay.
III. Private Money Lenders
Perhaps the best source of funding for your no-money real estate deals is the private money lender. These individuals have money lying around, so to speak, and may be interested investing with you if you sell them on the investment (and yourself).
Your job is to carefully negotiate the interest rates and terms, ensuring you sufficiently entice the lender while keeping your fees as low as possible.
Hint: if you provide the private money lender with info on the estimated ROI on the investment, as you can with rental properties from Pioneer Homes, you have a better chance of closing the deal. (Real estate returns often far exceed those from other investments, like stocks and bonds.)