Real estate flipping provides several potential benefits, from profits to artistic expression. It’s something you can do on your own, with the help of proper financing, of course. However, the last thing you want is to take on an unexpected partner – the Internal Revenue Service. Taxes are a reality, and even if you can’t avoid them, at the very least you want to be prepared for them.
Let’s clear up some confusion right away. If you buy a home, move in, spend a couple of years fixing it up and then sell it for (hopefully) a profit, you are an investor. If you, on a continuing basis, buy a home, fix it up without taking occupancy, and sell it within a year for profit, you are a home flipper, or what the IRS calls a dealer. In other words, dealers run home flipping as a business rather than a lifestyle, and it is you we are addressing in this blog.
Here are the salient facts regarding taxation of home-flipping dealers:
- Your properties are considered inventory, rather than capital assets. As such, you must pay ordinary income tax on any profits arising from sale – you do not get to treat the profit as a capital gain.
- You cannot avoid income tax by “rolling over” the profits from one home flip into the purchase of another home.
- The profits you make as a dealer are subject to self-employment tax – Medicare and Social Security tax. The rate is 15.3 percent on your annual net self-employment earnings up to $117,000. After that, earnings are subject to the 2.9 percent Medicare tax, plus an additional 0.9 percent on income in excess of $200,000 ($250,000 for joint filers).
- You will have to file quarterly estimated payments once you earn $400 for the year. However, if you also work as an employee separate from your home-flipping business, you may be able to increase the withholding on your wages enough to avoid the quarterly estimated payments.
- Home flipping is costly, but many of those costs must be capitalized rather than deducted as expenses. Capitalized costs are added to the purchase price of the property (the cost basis of the home), thereby reducing the amount of taxable net profit when you sell the property. Capitalized costs include:
- The purchase price of the property
- Direct labor
- Direct materials
- Equipment depreciation
- Indirect labor
- Insurance
- Production period interest
- Real estate taxes allocable to each project
- Rent
- Utilities
As you can see, home flippers must fully understand the tax implications of their business in order to comply with IRS rules. Failure to do so could get you into hot water for underpayment of taxes, which is a very bad thing. We suggest you utilize the services of an accountant, at least when you first start off, to help you understand the various tax rules, your responsibilities under them and the tax breaks you are entitled to. That way, you can make a nice profit from home flipping without arousing scrutiny from the IRS.