When you consider all the factors that affect the profitability of your fix-and-flip business, taxes loom large. The IRS will take a nice chunk of your profits, leaving you less to reinvest in your next project. Normally, your profits are taxed as ordinary income at your marginal tax rate. In Part Two,
we will discuss how to ensure you account for your project expenses so that you squeeze out every penny of deduction that you deserve.
In this part, we’ll address the holy grail of house flippers: How to pay lower tax rate on your profits. This is not easy to do. For starters, if you engage in fix-and-flip projects, the IRS will regard you as a dealer and your house-flipping will not be considered as passive investing. The result is that you’ll
pay ordinary tax rates, from 10 percent to 37 percent, on your profits. You’ll also have to pay self-employment tax (that’s Social Security and Medicare tax). If you can convince the IRS that you are not a dealer, you can qualify for capital gains treatment on your profits. Long-term capital gains rates range from 0 to 20 percent, much lower than your ordinary income tax rate. How do you work this magic?
Here are some ideas:
- Hold property for more than a year: The longer you hold the property, the better the chance you can be treated as a passive investor. If you rent out the fixer for a year or two before you sell it, you might qualify for long-term capital gains taxation.
- Do a 1031 exchange: Building on #1, instead of selling the house after holding it for a year or two, exchange it for another house. This is called a 1031 like-kind exchange, and we’ll devote a whole blog article to it soon.
- Live in it: After you finish fixing up the place, make it your primary residence for at least a year. Extra bonus: if you live in it for two years, and you might be able to sell the house tax free, due to the homeowner’s exception.
- Take all your deductions during the fix phase: Whether you end up paying taxes on ordinary income or capital gains, you should always take the deductions on indirect expenses that you can deduct before you sell the property. These include vehicle expenses, interest on your loans, the cost of building permits, insurance premiums and other indirect expenses.
The IRA Alternative
Here’s another idea to consider: Buy-and-lease. Instead of flipping the property, making it a long-term rental. Why? Because if you have it managed by a third party, you can buy the property in your self-directed IRA as a passive real estate investment. The IRA pays all the bills and earns the net rental income, which grows tax deferred in your IRA. You don’t pay taxes until you withdraw money from your IRA. This works as long as you don’t interact directly with the property – you can’t go over to fix a plumbing problem, because then you are an active investor and you’ll blow up the deal. Typically, the IRA custodian will be a property management company that sees to all the details. Consult a tax advisor to get the full facts on this fascinating alternative.