The Key Tax Consequences When Flipping Homes
Flipping properties has proven to be an excellent opportunity for investors across California, offering a profitable way to benefit from real estate without the hassle of managing rental property as a landlord. Savvy investors know how to spot a deal, buy quickly, make key updates, and sell for big gains, creating a main or passive income stream.
However, there is more to fixing and flipping houses than enjoying your profits. As with any income-generating practice, there are tax consequences to consider. Before getting involved in real estate investing – or in growing your operations if you currently have a small portfolio – be sure to keep these key tax consequences of flipping properties in mind.
Determining the Difference Between an Investor and a Dealer
Think there is only one way to approach taxes as a fix and flip investor? Unfortunately, this is not the case – and which bucket you fall into can play a significant role in how you are taxed, and the amount of money you may owe to the IRS.
There are two tax treatment alternatives for those who flip properties: investors and dealers. The IRS considers multiple factors in determining whether someone is an investor or a dealer. As a general matter, if you are purchasing land with the intent to subdivide the property and sell plots to customers in the ordinary course of business, you will most likely be considered a dealer. On the flip side, if you hold a property for several years without any effort to promote or develop the property, you will probably be considered an investor.
Tax treatment for dealers and investors differs upon the sale of the real property, whether the sale results in a gain or a loss. Investors receive the benefit of preferential tax treatment on gains, whereas dealers receive more advantageous tax treatment on losses. To account for any misclassification – or to attempt to argue your case to the IRS if you disagree with a ruling – make sure you retain complete documentation of your investments, and always consult with your tax professional before undertaking an investment decision.
Active vs. Passive Income
Another factor to keep in mind when filing taxes is the difference between passive and active income. Active income requires you to materially participate in a work-related activity to earn money, while passive income comes from owning income-producing assets. Active income is typically taxed at normal income tax rates, but passive income taxes can vary – they can be taxed at a lower rate, at your regular income tax rate, or at a higher rate, depending on how the income was earned.
Many investors expect that income from investing in real estate will be classified as passive income, since it may not be their primary job or since it differs from a typical W-2 job with a steady paycheck. Indeed, rental income earned from real estate investments is generally taxed as passive income. However, because flipping houses requires much more active participation than simply collecting rent, the IRS is likely to see income earned upon the sale of a property flip differently. Active income, unfortunately, comes with the added tax burden of payroll taxes, such as Social Security, Medicare, and federal and state unemployment taxes, since the income is generated from work that was performed. The result is that taxes on a property flip are subject to higher overall tax rates.
Some investors argue that because hired professionals are doing most of the labor involved in fixing and flipping a property, from contractors to painters to plumbers, they are taking only a passive role in income generation. However, the IRS sees this differently, because the investor is actively involved in readying a house to sell, whether the investor is doing the work themselves or outsourcing to a third-party vendor.
The Pains of Incorporation
Some investors are fine operating as a sole proprietorship – essentially using a pass-through entity that does not have to be established or formed – but others, especially those who want more protections and the opportunity for tax benefits may choose an alternate path. However, which option to choose, and how making a choice can impact taxes, is something all investors should keep in mind.
For most people, a business form like a limited liability company (an LLC) will be adequate to safeguard against personal liability, but more active investors may have other strategies in mind. Some will form S-Corporations, which can have tax advantages over LLCs, while others will formally incorporate as a C-Corporation. While all these organizational options have pros and cons, it is best to understand them – and the associated paperwork and cost – before moving forward.
If you are not sure which option is best for you, or even whether this is a step you need to take, be sure to speak to a professional, like a CPA or real estate lawyer.
Capital Gains Income
Capital gains tax applies to both long-term and short-term investments sold for a profit, but there is a notable difference in tax treatment between the two. Which one will apply to your situation – and, in turn, how much in tax you will be required to pay – will depend on your personal investing activities.
Long-term capital gains tax is the preferred option for most taxpayers, as tax rates tend to be lower. Applicable for properties held for at least a year, long-term capital gains are taxed at 0%, 15%, or 20% based on the income cap thresholds, which change year to year.
If you expect a faster turnaround on the properties you fix and flip, long-term capital gains tax will not apply. And, unfortunately, the tax situation for shorter term holdings is less desirable. Short-term capital gains are taxed as ordinary income, which means at the same rate as the rest of your annual earnings. For those with minimal taxable income, this may not be of consequence, but for high earners, including those who generate significant income from real estate investments, this can mean marginal federal tax rates as high as 37% as of 2023. This can be a big blow, resulting in thousands or even tens of thousands in taxes simply because an asset was purchased and disposed of within less than a year.
Deductible Expenses vs. Capitalization
For those not experts in tax, it is easy to fall into the deductible trap – in other words, believing everything can be “written off” when tax time comes around. Unfortunately, this can result in misunderstandings related to income and profits at tax time. Contrary to the beliefs of some new real estate investors, not all expenses associated with the process of flipping a property can be deducted. This can mean a reduction in expected tax savings. For investors who have not yet filed tax returns on their investments, it is important to keep track of expenses throughout the process, as well as to understand what is and is not deductible.
For the most part, expenses associated with fixing and flipping cannot be deducted – they must be capitalized, which means incorporated into the basis of the property. Whether or not this capitalization will result in a profit post-sale depends on the final basis of the property compared to the amount for which a property is sold. Some of the costs that must be capitalized include:
- Materials to make improvements
- Paid labor to make improvements
- Utility costs
- Rent expenses, if applicable
- Insurance on the property
- Equipment expenses
- Real estate taxes on the property
Without documenting each of these costs, it may be hard to demonstrate the adjustment to cost basis, so keeping methodical and accurate records should always be a part of your process. Should the IRS audit your operations, you want to be able to prove that the value of your property can be supported with reliable documentation.
The Role of Tax Extensions
While April 15th is traditionally Tax Day in the United States, this does not mean you have to have every piece of tax paperwork in the hands of the IRS by midnight. In fact, many investors, especially those with complicated business arrangements, may need more time to collect and file all required information. Luckily, there are practices in place to extend a tax return, which can be an important advantage for those with multiple property sales within a year – and the paperwork that goes with it.
Some investors believe that requesting an extension to file taxes is a good way to save money, or at least make the best use of profits. After all, if you do not file, you do not know what you owe and thus do not have to pay, right? Unfortunately, this is a common misconception. An extension to file taxes only changes the deadline for the actual tax paperwork; it is not an extension to pay. As such, the IRS still expects a payment of your best estimate of taxes due to be made by April 15th.
Calculating estimated tax payments is not always easy, but is possible using standard IRS tax forms or estimated payment calculators. However, if you want to ensure your payments are as accurate as possible, a tax prep professional can help you determine your potential tax liability.
Quarterly Estimated Tax Payments
For the average American, filing taxes once per year is perfectly fine. However, those with more complicated tax situations may find themselves in a different boat entirely. If you are generating a lot of income, like self-employment income or investment income from flipping houses, that is not taxed at the source, you may wind up with a hefty balance due at the end of the year. And since the IRS likes its money in a timely manner, this can result in a need for quarterly estimated tax payments.
According to the IRS, anyone who expects to owe more than $1,000 as a sole proprietor, partner, or a shareholder in an S corporation, or more than $500 as a corporation, should plan to pay estimated taxes throughout the year. The first year of investment activities may not require these tax payments so long as prior year tax liability owed was $0, but after this, prepare to make payments in April, June, September, and January.
The Expense of a Tax Prep Professional
Many Americans do their taxes at property independently using software programs like TurboTax. While most households do fine with these kinds of tools, particularly for those who have nothing more to account for than a few W-2s, standard investment accounts, and perhaps deductions and credits related to things like having children, those engaged in more extensive investment activities may require more help to ensure all applicable rules are being followed.
However, tax professionals do not always come cheap. The more complicated your tax situation, the more a CPA or IRS Enrolled Agent is likely to charge. If you want a skilled professional to account for the ins and outs of your investment activities, expect to make your chosen tax partner an investment, too.
Should you consider going to a pop-up tax service that utilizes trained agents rather than pros with professional certifications, don’t. While this option can be much cheaper than paying for an expert, you are far more likely to end up with an error-filled return or missed opportunities for savings without the advice of someone who is highly knowledgeable in real estate transactions.
As with many aspects of the world of real estate investing, taxes for property flippers are anything but straightforward. This is particularly true for experienced investors buying and selling many properties per year. If you are looking to grow your portfolio or seeking bigger gains as an investor, understanding the potential tax consequences of fixing and flipping is key. By knowing the ins and outs of everything from capital gains taxes to when to make estimated payments, you can make the best possible choices for your future investment goals.
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