Flipping real estate can be incredibly lucrative, but real estate investors need to understand how paying taxes on flipping houses works to avoid a very unpleasant tax season.
In this article, we’ll discuss the tax implications of this real estate investment strategy, including what kinds of deductions you can make, the IRS tax regulations, what risks you undertake when house flipping, and how you can rely on professionals for assistance in minimizing your taxes.
There are a number of deductible expenses that you can report to help reduce your tax bill. Some can help you save money before you sell the property, but others can only be claimed after the sale. As you start flipping houses, be sure to meticulously document these expenses to alleviate your tax burden.
Travel Expenses
Things like plane tickets and vehicle expenses, like gas and wear and tear, can be deducted. Not only does this help compensate you for car maintenance, but it can also provide excellent tax benefits if you happen to be working on a house far away from your home.
Office Expenses
These include expenses for a physical place of business, such as rent, utilities, stationary, and office supplies. If you have a home office, you can reduce your income tax proportionate to the square footage of the home office in proportion to the rest of the house.
Business Expenses
Things such as property taxes, building permit costs, and real estate commissions would all be considered business expenses. This often includes the cost of professional memberships and accreditations.
Professional Fees
Legal and accounting fees are considered professional expenses. You can save up on your taxes by deducting real estate attorney and tax professionals’ fees.
After-Sale Deductibles
Some tax deductions are only available after selling properties — they’re capitalized into the original basis of the house. This includes the purchase price and costs such as building materials, labor, insurance, equipment depreciation, and real estate taxes.
IRS Rules and Regulations for House Flipping
The IRS classifies house flipping gains as active income, not passive income like rental income. This means the real estate investor will pay taxes within their ordinary income tax bracket. Here’s what this means for you.
Flipper Classification
The IRS gives real estate dealer status to every house flipper, which means that professional house flippers are identified the same as those who flip houses as a side gig. Real estate dealers are seen as business entities even if they don’t incorporate. As you’ll be working for yourself, you are subject to self-employment taxes on any windfall you make.
Reporting Requirements
Sole proprietors, LLCs, and S Corps who are flipping houses need to report their net profits quarterly. These estimated taxes are due April 15th, June 15th, September 15th, and January 15th of the following year. You will use a Schedule C form for these estimated taxes.
Consequences of Non-Compliance
Failing to pay house flipping taxes can result in major consequences. You’ll start to accrue interest on the taxes, which can eventually lead to liens on the property and even garnishment of your wages. It’s best to seek good tax advice and ensure you’re paying everything due on your taxable income, even if it’s frustrating.
What Is the Risk of Flipping Property?
While you can make a profit off house flipping, this does not mean it is risk-free. There are a variety of different pitfalls that await the unwary house flipper, especially during tax season. Consider all of these elements before you decide to dive in.
Financial Risks
The most prominent concern for a house flipper is losing money. You may underestimate how much work a house takes before it’s sellable, or you may overpay for construction costs. As commercial properties have higher loan interest, you may be paying more than you should in interest.
It may help to look at all your options, including some alternatives to hard money lenders. If you fail to estimate how much tax you need to pay and then underpay the IRS, you can find yourself with liens on the property.
Legal Risks
There are tight rules on house flipping to protect the market, which includes the Anti-Flipping Rule, which limits how many times a house can be sold. A seller may not have the title to the home, or you may accidentally fall afoul of zoning laws.
Market Risks
It’s possible for the market to drastically change while you’re fixing up the home, leading property values to drop significantly. You may then have to sell at a loss. If this sounds too intimidating, you can always buy a house, fix it up, and then develop a strong rental income by holding it for longer.
Strategies to Minimize Taxes on House Flipping
As income tax can eat into your profits, you need to know how to reduce your tax burden as much as possible. These options can be very beneficial in reducing your taxes.
Holding Periods
If you hold the property for over a year, you will be able to switch out your self-employment tax for long-term capital gains tax, which can be a lower rate if you have a lower sales volume — sometimes as low as 0%.
Legal Entity Structuring
If you structure yourself as an S Corp and pay yourself a “reasonable salary,” you will pay the 15.3% self-employment tax rate on your salary amount. You can also choose between paying yourself a salary and receiving dividends, with dividends being subject to a lower tax rate.
Reinvestment Options
While you may not be eligible for the Section 1031 like-kind exchange, you may be able to use the QOZ program for investments in certain areas as long as you reinvest within 180 days. You can use it to offset losses from other investments, reducing taxes while still making a profit.
Professional Advice and When to Seek It
Working with a qualified tax professional is always a good idea to develop a strong investment strategy. Taxes on a real estate investment can be complicated, especially if you are doing it as a side job. Here are some circumstances in which you should absolutely seek help from a professional familiar with the needs of real estate investors.
Complicated Tax Laws
If your filing status changes for whatever reason during the course of a year, such as getting married or divorced, you will need to discuss how this will change your income tax.
There’s a major difference between self-employment tax rates and capital gains rates, and a tax professional can assist you in determining your next step. You may also not be able to forestall capital gains tax, as these breaks aren’t always possible for a real estate dealer.
Large Investments
A real estate investor who is flipping multiple houses at once should talk to an accountant to untangle the self-employment taxes. This is especially true if some of their capital assets are under a year old while others have been in their possession longer; these are classified differently upon sale.
New House Flippers
If you are new to the business, a tax professional can help explain all of the nuances of tax law to you, such as how to file self-employment tax and how to itemize your deductions. They will be able to help you calculate net profit and discuss the capital gains taxes.
