Flipping Houses Taxes: Capital Gains vs Ordinary Income
Flipping houses is generally not considered passive investing by the IRS. Tax rules define flipping as “active income,” and profits on flipped houses are treated as ordinary income with tax rates between 10% and 37%, not capital gains with a lower tax rate of 0% to 20%. Taxes on flipping houses will usually include self-employment tax.
Flipping Houses: Capital Gains or Ordinary Income
If an investor is categorized by the IRS as a “dealer,” the profits from property flips will be taxed at their ordinary income tax rate. The profit is calculated by subtracting the expenses, including the purchase price, from the final selling price. Tax brackets range from 10% to 37% for “active investors” earning active profits.
According to the IRS, a real estate dealer purchases real estate and sells it to customers “in the ordinary course of his or her trade or business.” Most fix-and-flip investors are considered dealers; they hold their properties short term and the majority of their income is derived from flipping houses. Even real estate investors who occasionally flip houses are typically considered dealers and are taxed at ordinary income rates.
On the contrary, profits made from properties held more than 12 months are typically subject to more favorable long-term capital gain brackets ranging from 0% to 20%. An investor can choose to rent the property out or occupy the property. To track fix-and-flip profits and expenses, we recommend using accounting software. Check out our best accounting software article.
Ordinary Income Tax Consequences When Flipping Houses
If you’re 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 37%. In addition, the profit is subject to self-employment tax (the self-employed person’s equivalent to FICA), which is 15.3%, double what you typically pay as a W2 employee.
As a dealer, the total tax consequence on a flip can range from as low as 25.3% to as high as 52.3%, 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.
To do this correctly, you should use an accounting software like QuickBooks Online. Their software helps track what you spend with vendors, contractors, interest, and more—all items you can deduct from your gross profit.
When Capital Gain Taxes Apply to Flipping Houses
If you’re fortunate enough to avoid the dealer definition, deriving the majority of your income from flipping houses and selling the houses after one year, then you’ll be taxed at the lower capital gains rates on the profit from the sale.
Keep in mind that this is rare for most flippers; the majority of the time they’re taxed at the ordinary income tax rate, but we want to mention it since it does happen. Even better, if you qualify for capital gains tax treatment, you don’t have to pay self-employment tax.
Short-Term Capital Gains Taxes on House Flipping
If the property is held less than 12 months, the profit from the flip isn’t given any preferential treatment. Short-term capital gain is taxed at ordinary income tax rates whether you’re defined as a dealer or investor. However, you have the benefit of not paying 15.3% self-employment tax, so there are good savings nonetheless.
Long-Term Capital Gains Taxes on House Flipping
If you hold property for one year+ and aren’t classified as a dealer, the profit from the flip will be taxed according to long-term capital gains rates. Currently, those rates range from 0% to 20% for most taxpayers. Compared to the one-two punch of ordinary income tax rates and self-employment tax, it’s quite a savings.
“The trick that flippers know is if you hold onto the property for over a year, and then earn a profit on the sale, you’ll pay long-term capital gains taxes, which max out at 20%. The less-than-one year short-term capital gains trick is to play a flip that didn’t make a profit against one that did. This reduces the net capital gains you’ve earned and thus your taxes on them.”
– Brian Murphy, Attorney, Real Estate Broker & Tax Prep Educator, At Your Pace Online
Whether you own a small business and are filing as a dealer or are filing as an investor, TurboTax provides customary tax software. You can quickly import all of your expenses and file your taxes online. If you have questions, you can chat with their team of support staff and have your return checked before filing so that you get your maximum refund—guaranteed.
How Taxes on Flipping Houses Are Calculated
Ultimately, you’re going to be taxed on your fix-and-flip profits, which is your sales price minus total expenses and deductions. The profit is calculated by subtracting the expenses, including the purchase price, from the final selling price.
“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 means you’re considered a real estate dealer. Pretend your business is buying old lawn mowers, fixing them, and reselling them. This is a lawn mower business, just like flipping houses is also a business.”
– Nathan Byers, CPA/PFS, JBC Wealth Advisors
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.
When thinking about what your profit is, consider only the purchase price, not the amount you financed into your profit equation. The IRS doesn’t take your financing into consideration when calculating profit. However, you will be able to deduct the interest paid as an expense.
Expenses beyond the purchase price include mortgage interest and points, loan fees, materials and supplies, labor, closing costs, taxes, professional services, and all the marketing costs and real estate agent commissions involved in selling the property. This table provides a good snapshot of what to consider.
As with the purchase price, the IRS is not concerned about how you paid for an expense. As long as it was an expense tied to the property, it is typically deductible. For example, if you charge $10,000 on your Lowes credit card for building materials, that is considered an expense of renovating the property.
Profit is the amount you’ve cleared on the sale after all expenses, including the purchase price, are taken into consideration. One of the most important things you can do is keep excellent records of your expenses to ensure you deduct all renovation costs. The basic formula is: Transaction Profit = Selling Price – Purchase Price – Expenses.
Keep in mind when calculating your profits for IRS reporting that this may not be your actual profit. For example, if you have to pay off mortgage debt used to finance the purchase and renovations, it eats into your bring-home funds. You can estimate this amount with this formula: Selling Price – Mortgage – Expenses = Bring home profit to the investor.
From there, you multiply your taxable profit by your ordinary income tax rate, which gives an estimated annual tax burden. Keep in mind that you can use losses from other fix and flips completed in the same year to offset gains.
Example of Taxes on a House Flip
Let’s run through a basic scenario to demonstrate the fundamentals of how flipping houses taxes are computed. We’ll use four 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%.
- We will consider the effect of self-employment tax.
House Flipping Tax Example
|Purchase Price and Expenses||Cost|
Loan Origination & Points
Purchase Closing Costs
Interest During the Rehab Period
Materials Cost for Rehab
Contractor’s Labor& Other Costs
Insurance During Holding Period
Travel Related to the Purchase/Rehab/Sale
Selling Commission & Closing Costs
Total Expenses Not Including Purchase Price
Total Expenses, Including Purchase Price
Profit (Selling Price – Total Expenses)
- 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. Keep in mind that the investor can’t consider the $26,500 as if it’s theirs to spend since Uncle Sam needs his portion.
How to File & Pay Your House Flipping Taxes
After you calculate your flipping houses taxes, you need to know when to file them and how to pay them. Generally, if you’re a sole proprietor, part of an LLC, or registered as an S corporation, and your house flipping business is making over $1,000 per year in profits, then you should pay quarterly taxes.
If you’re not generating revenue yet or meet other exemptions, you will file your taxes at the end of the year. However, most house flippers pay quarterly taxes. These quarterly taxes are known as your estimated taxes, and they’re generally due April 15th, June 15th, September 15th, and January 15th of each year.
For example, the income you earned flipping houses from January 1st through March 31st is due April 15th. However, if these dates fall on weekends or holidays, your taxes will be due the next business day.
Schedule C Flipping Houses
You will need to fill out a Schedule C for these estimated taxes. This form is also referred to as a 1040 Profit and Loss Form. For more information on how to fill this form out, check out our in-depth Schedule C guide that includes step-by-step instructions for filling out the form.
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.
“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. You can also claim additional expenses related to dealer activities.”
– Noel Dalmacio, CPA, CFP & founder, Dalmacio Accountancy Corporation
How to Save Money on House Flipping Taxes
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 things like holding onto an investment for a longer period of time or even owning the property as your primary residence.
Here we discuss four ways to reduce your taxes when flipping houses:
1. Hold Investment Property for More Than a Year
If you find yourself in the category able to pay capital gains tax instead of ordinary income tax, forecast whether holding the property for a year or more will work. Remember that 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.
“Section 121 of the Internal Revenue Code allows a taxpayer to elect to exclude up to $250,000 ($500,000 for taxpayers who file a joint return) of the gain from the sale of property owned and used as a ‘principal residence.’ ‘Principal residence’ means the property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more of the five years before the sale. This gain on the sale exclusion is limited to one sale or exchange every two years. So, it should be used selectively by flippers of multiple properties and elected with respect to the flip transaction likely to result in the largest taxable gain.”
— Brian J. Thompson, CPA & Attorney, BrianThompsonLaw.com
3. Do a Tax-Deferred Exchange for the Flip
A tax-deferred exchange, also known as a 1031 exchange, allows you to 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.
4. Claim House Flipping Tax Deductions
The IRS allows house flippers to write off certain expenses that pertain to purchasing, renovating, and selling properties. Writing off these expenses helps reduce your taxable income. You can deduct some expenses before you flip the property, but other expenses, such as capital expenditures, can’t be deducted until after the property sells.
Expenses You Can Deduct When Flipping a House
It’s important to know what expenses you can deduct when flipping a house. This will give you a better idea of how much your taxable income will be, so you can have money set aside to pay your taxes. This, in turn, affects your budget on your next flip.
Some expenses you can deduct when flipping a house include:
- Capital expenditures (expenses related to buying and renovating a house with the intention to flip). These are deducted after you flip the property.
- Vehicle expenses, which can include gas and repairs or a standard mileage rate.
- Office expenses, including rent, utilities, and office supplies like printer ink and paper
- Building permits
- Mortgage interest
What Determines Dealer Status for a Real Estate Flipper
A business that regularly profits from selling an asset, whether it’s a property, a vehicle, or inventory, is classified as an active business. Therefore, an investor who flips properties will likely be classified by the IRS as an active business—a “dealer” in houses—and is subject to ordinary income tax on the profits.
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.
This is in contrast to passive investment income such as a rental property on which, if eventually sold, the profits will be taxed at a more favorable capital gains rate. However, the IRS code isn’t particularly clear on what constitutes active versus passive income, and many factors are taken into consideration. These can include how many properties are flipped, if they’re owner occupied or rented for a period of time before resale, and how long they are held.
If you’re an active fix and flipper who holds a property for less than one year, you’ll most likely be taxed at your ordinary income tax rate of 10% to 37%. Determining your taxation category and the rate you owe is complicated, and your tax professional should be involved.
Frequently Asked Questions (FAQs) on House Flipping Taxes
This guide breaks down house flipping taxes and discusses capital gains versus ordinary income when flipping houses. These are some frequently asked questions we’ve encountered and answers that might give you further insights.
What Is the 70 Rule in House Flipping?
The 70 rule tells investors the maximum they should pay for a property. The rule, which is a guideline in the industry, says an investor should not pay more than 70% of the estimated value of the property after they complete all their repairs and renovations (ARV).
For example, if an investor wants to purchase a property with an ARV of $200,000 and $25,000 in needed repairs, they should pay $115,000 ($200,000 x 70% = $140,000; $140,000 – $25,000 = $115,000).
What Are Other House Flipping Deductions?
When thinking about your real estate investing expenses and deductions, make sure to consider things like transportation, home office, meals, and education like workshops, books, etc. Speak to your accountant to learn more and use an online tracking system like QuickBooks online to keep it easy.
Can You Really Flip Houses with No Money?
There are several ways to flip houses with no money, but you will need to contribute to a deal in creative ways (e.g., if you have building knowledge, contribute with your time and skills, or have a property you can use to cross collateralize for a hard money loan).
Do I Need a License to Flip a House?
Typically, you don’t need a particular state license to flip a house, but check with your state, as it could depend on how your business operates. For example, if you are a developer, some states require a contractor’s license. In most cases, you will need to properly apply for permits and possibly a business license.
Bottom Line: Flipping Houses Taxes
In 2017, house flips hit an 11-year high, with over 200,000 flips in the U.S. Following this enthusiasm, you need to know what taxes you’re responsible for paying on your house flipping business. 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.