Flipping houses is generally not considered passive investing by the IRS. Tax rules define flipping as active income and profits on flipped houses treated as ordinary income, not capital gains. Taxes on flipping houses will usually be based on the investor’s normal income tax rates and will also include self-employment tax.
If you can make an after-tax profit on house flipping you’ll want to check out LendingHome. They’re an online hard money lender that offers fix and flip and rehab loans to short-term investors up to 80% LTV and 90% LTC. Rates start as low as 7.5% for prime borrowers and the application takes minutes.
House Flipping Tax Rules
A business that regularly profits from the sale of an asset, whether it’s a vehicle, inventory, or a piece of real estate is classified as an active business process. As a result, a person flipping real estate, particularly if it involves multiple properties, will likely be classified by the IRS as an active income – a “dealer” in houses – and will be subject to ordinary income tax on the profits.
This is in contrast to passive investment income such as a rental property which, if eventually sold, the profits will be taxed at more favorable capital gains rates. Ultimately, this means that the tax consequences of flipping houses depend on whether the IRS categorizes the person as an active real estate dealer or a passive real estate investor.
Whether or not you’re a passive investor or a dealer, H&R Block tax software can accommodate you. Not only can you file your taxes quickly online, but you can easily upload your prior years tax information and you have the option to have your return checked by a Tax Pro before filing.
What Determines Dealer Status for a Real Estate Flipper
The IRS code is not particularly clear on what constitutes active versus passive income. Many factors are taken into consideration. These can include how many properties are flipped, if they are owned or rented for a period of time before resale, and how long they are held.
Most likely, a person flipping a single house over a long period or turning over a rental property for a profit will not be viewed through the lens of an active dealer in real estate. That’s particularly the case if they lived in it or rented it, and held it for several years before resale. The tax liability on such flips will be more favorable than the tax liability for a real estate dealer.
On the other hand, a fix and flip investor who flips a dozen houses a year, holds them for a very short period, and/or derives most of their income from their real estate flipping business will be considered a dealer and the income will be taxed at higher ordinary income rates. Determining your taxation category and the rate you owe is complicated, and your tax professional or CPA should be involved.
Typically, if you hold a property for more than a year you won’t be considered an active dealer and be subject to long-term capital gains taxes between 0% – 20%. If you’re an active fix and flipper that holds a property for less than one year, however, than you’ll most likely be taxed at your ordinary income tax rate of 10% – 39.6%+.
“One reason real estate taxation is so difficult is because
of the active versus passive activity designation. The idea of flipping a house is that you intend to buy it, fix it up, and sell it. This intent means you are considered a real estate dealer. Pretend your business is buying old lawn mowers, fixing them, and reselling them. You are operating a business. You can have a similar business that substitutes houses.” — Nathan Byers of JBC Wealth Advisors.
Ordinary Income vs Capital Gains Taxes on Flipping Houses
If the investor is categorized by the IRS as a dealer, the profits from most property flips will be taxed at their ordinary income tax rate. There are minimal exceptions that will be covered below, but most profits will be taxed at the investor’s prevailing income tax bracket between 10% – 39.6%+.
Real estate investors who only occasionally flip houses may have certain flips taxed at ordinary income rates. However, depending on certain details, the deals may be considered passive investments and subject to more favorable capital gains taxes between 0% – 20%. Properties held for more than a year and rented to tenants, or even lived in by the investor can help push a deal into that passive investment category.
Ordinary Income Tax Consequences When Flipping Houses
If you are classified as a dealer, the profit from a flip will be taxed at your prevailing ordinary income rate. Currently, ordinary income tax rates range from 10% to 39.6%. In addition, the profit is subject to self-employment tax (the self-employed person’s equivalent to FICA) which is 15.3%.
So, as a dealer, the tax consequence on a flip can range from a low of 25.3% to as high as 54.9% depending on your tax bracket! Needless to say, you don’t want to misperceive your profits as fully belonging to you – Uncle Sam gets a big chunk of them!
When Capital Gains Taxes Apply to Flipping Houses
If you are fortunate enough to avoid the dealer definition (at least on occasional flips) then you’ll alternatively be taxed at the lower capital gains rates on the profit from the sale. There are two capital gains rates: short-term capital gains for properties held under 1 year; and, long-term capital gains for properties held a year or more.
Even better, if you qualify for capital gains tax treatment, you don’t have to pay self-employment tax. So, there is 15.3% in potential savings.
Short-Term Capital Gains Taxes On House Flipping
If the property is held less than 12 months, the profit from the flip will isn’t given any preferential treatment. Short-term capital gain is currently taxed at ordinary income tax rates whether you are defined as a dealer or investor by the IRS. However, you do have the benefit of not paying self-employment tax so there are good savings nonetheless.
Long-Term Capital Gains Taxes On House Flipping
If you hold the property for a year or more and are not classified as a dealer, the profit from the flip will be taxed according to prevailing long-term capital gains rates. Currently, those rates range from 0% to 15% for most taxpayers, and up to 19.6% for high-income individuals.
Compared to the one-two punch of ordinary income tax rates and self-employment tax, it’s quite a savings.
H&R Block provide customary tax software, whether you are filing as a dealer (own a small business) or as an investor. With H&R Block, you can quickly import all of your expenses and file your taxes online. If you have questions, you can chat to their team of Tax Pros and have your return checked before filing, so that you get your maximum refund, guaranteed.
How Taxes on Flipping Houses Are Calculated
Ultimately, the tax that’s charged, whether at ordinary rates or capital gains rates is a function of the profit derived from the flip. The profit is calculated by subtracting the expenses (including the purchase price) from the final selling price.
The purchase price includes the cost of the house itself. While you might view closing costs, points, etc. as part of the purchase price, for ease of accounting everything beyond the actual purchase of the building itself is best treated as an expense.
Expenses beyond the purchase price include interest and points, loan fees, materials and supplies, labor, closing costs, taxes, professional services, and all the marketing costs and commissions involved in selling. This table provides a good snapshot of what to consider
Profit is the amount you’ve cleared on the sale after all expenses, including the purchase price, are taken into consideration. The basic formula is:
Profit = Selling Price – Expenses
An Example Of Taxes On a Flip
Let’s run through a basic scenario to demonstrate the fundamentals of how taxes are computed on a flip. We’ll use 4 assumptions:
- The investor is considered to be a dealer by IRS guidelines, so the profits will be subject to ordinary income tax;
- The property gets flipped in 10 months further pinning it to ordinary income tax;
- The investor’s ordinary tax rate is 23%; and,
- We will consider the effect of self-employment tax
House Flipping Tax Example
|Loan origination and points||$1,000|
|Purchase closing costs||$600|
|Interest during the rehab period||$200|
|Materials cost for rehab||$9,000|
|Contractor’s labor and other costs||$23,000|
|Insurance during holding period||$200|
|Travel related to the purchase/rehab/sale||$100|
|Selling commission and closing costs||$4,000|
|Total Expenses Not Including Purchase Price||$28,000|
|Total Expense Including Purchase Price||$78,500|
|Profit (Selling Price - Total Expenses)||$26,500|
- So, this flip deal has $26,500 in profit
- The investor’s ordinary tax rate is 23%, so the income tax owed on the flip is $6,095 ($26,500 x 23%)
- In addition, the profit is subject to self-employment tax of 15.3%, so that’s an additional $4,055 ($26,500 x 15.3)
- That brings the total taxes due to $10,150 on this flip.
Starting with the $26,500 of profit, then subtracting what’s needed to pay taxes, the investor is left with $16,350. Again, the investor can’t consider the $26,500 as if it’s theirs to spend. Uncle Sam wants a good chunk, leaving the investor with a little more than $16,000.
Keep Good Tax Records When Flipping Real Estate
Because expenses are so important to reducing your taxable income and therefore the amount of tax you’ll owe, it’s vital to keep good track of every expense related to a flip. No matter how insignificant some expenses may seem, they all matter – and they all add up!
Whether you try a do-it-yourself route and set up a spreadsheet for your records, use real estate investing software, or accounting or bookkeeping software, be sure to do something to keep an accurate accounting of your flips. Come tax time, it will matter because every dollar that’s not spent on an expense is subject to taxes.
Noel Dalmacio, CPA, CFP founder of California-based Dalmacio Accountancy Corporation notes the importance of keeping good records for flipping:
“If you are considered a real estate dealer, there are some
factors to consider. You can claim unlimited losses to offset ordinary income like salary and business income. And, you can claim additional expenses related to dealer activities.”
Ways to Pay Less on Taxes When Flipping Homes
While working around the basic consideration of flipping as active income is difficult, there are some special cases that can help you flip a property and not be subject to ordinary income tax. These include such things as holding onto an investment for a longer period of time or even owning the property as your primary residence.
1. Hold Investment Property For More Than a Year
If you find yourself in the grouping able to pay capital gains tax instead of ordinary income tax, forecast whether holding the property for a year or more will work. Recall, if you hold the property for a year or more, you are subject to long-term capital gains tax rather than short-term.
Using our example above with the $26,500 profit, if you held the property sufficiently long, you would likely owe 15% or less in long-term capital gains tax. Moreover, you would not be required to pay self-employment tax because it’s considered an investment and not active income. So, your tax owed would be $3,975 or less as opposed to over $10,000 in the case above.
2. Make Property Your Primary Residence Before Flipping It
If you are casually flipping a single property, consider whether you could move into it as your primary residence after renovations are complete. If you move into the property, you can likely shift the tax consideration on the eventual sale from active income to capital gains. Plus, current tax laws allow that, if you live in the property two of the five years prior to sale, you may be able to avoid tax on the gain entirely.
3. Do a Tax Deferred Exchange for the Flip
A tax-deferred exchange, also known as a 1031 exchange allows you roll over the gains on one property to another. To qualify for this, you’ll need to hold the property for a year or more (longer is better in the IRS’ eyes) and rent it to tenants. It can’t be used just on a quick-turn property. For more information, you can read our ultimate guide on 1031 like kind exchanges.
Flipping a home is considered active income as opposed to passive investment income by the IRS. Profits from flipping houses are generally treated as ordinary income, not capital gains, so profits are subject to normal income tax and self-employment tax. In certain cases, investors may be able to treat profits as capital gains and be taxed at lower capital gains rates.
Make sure you check out LendingHome if you want to make a profit flipping houses. They’re an online hard money lender that offers fix and flip and rehab loans to short-term investors up to 80% LTV and 90% LTC. Rates start as low as 7.5% for prime borrowers.