As experienced real estate investors will attest, taxes due on a fix and flip can have a serious impact on profitability. While these types of real estate investments are great for quickly unlocking value, the taxes on flipping houses have to be considered and calculated at the start of every project.
Without a proper plan, the tax consequences of flipping homes can be steep. Thankfully, however, there are different strategies available to help you save money. In this guide to expert tax strategies for flipping houses, we give you a rundown of what your options are.
Or if you’re looking for other tax advice, read our guide to cash out refinances and taxes.
Taxes on flipping houses and long-term rental taxes – where do they differ?
Before we discuss strategies, it’s important to understand the difference between the taxes on flipping houses and long-term rental taxes, and why there is such a disparity between them.
The standard tax consequences of flipping a house, where you own the property for less than 12 months, is that the profit you make is subject to your standard taxation rate. This is due to the fact that the IRS classes any investment you own for less than a year then sell for a profit as ‘normal income’.
Moreover, if this is the case, the IRS categorizes you as “a dealer”, even if you may not consider your real estate investment as a ‘business’. You may work a full-time job and just flip houses as a side hustle. However, this doesn’t matter to Uncle Sam.
On the other hand, landlords are viewed differently. They’re considered long-term investors and are thus granted preferential tax treatment. That being said, don’t let this discourage you from fix and flip investing. There are tax strategies available that can reduce your liability.
Keep Hold of the Property For Over a Year
As mentioned, the reason why taxes are so high for standard fix and flips is due to the quick turnaround.
To demonstrate this, let’s look at two scenarios and the differing capital gains tax on flipping real estate:
- You’ve owned a property for 11 months and sell it for a profit – This profit is classified as a short-term capital gain. Therefore, it’s taxed at your ordinary-income tax rate.
- You own the same property for 13 months and then sell it on – Your profit is now classified as a long-term capital gain and is taxed at a lower rate (see below).
What difference does this two-month window make? Quite a bit.
Short-term capital gains are taxed at your normal income tax rate. At the time of writing, federal income tax rates range from 10-37% of your income. Moreover, due to being classed as a “dealer”, flippers have to pay double FICA taxes. Usually 7.65%, this shoots up to 15.3%. Combined, this results in a taxation rate between 25.3% and 52.3%.
On the other hand, long-term capital gains are not subject to FICA taxes and the tax on flipping houses owned over a year is between 0-20%.
If you’re looking to avoid a large tax bill, it may be worth revising your exit strategy to the 12-18 month window. If you’re going to acquire financing from a hard money lender, you can explore the possibility of a longer loan window. However, if your window is shorter than a year, you can refinance your loan. Before making any big decisions, speak to your lender as they most likely have experience in different tax strategies.
Look into a 1031 Exchange
If you’re looking to continually fix and flip and make your side hustle a full-time job, a 1031 like-kind exchange is a great tax strategy for flipping houses.
In a 1031 exchange, you can defer capital gains tax liability on the sale of an investment property. In return, you use the proceeds from the sale to buy a new property. If you do decide to use this kind of exchange, you need to make sure you follow certain steps and hit your time frames. This can be difficult if you’re fix and flipping during COVID-19.
If you do want to go down this route, you need to have a top real estate team on hand for advice and have an experienced tax professional in your corner.
Take ALL the deductions available to you
If you’re unable to do the above but have decided to make flipping houses a legitimate business, you want to ensure you take every single tax deduction that may be available to you.
These may include:
- Real estate taxes
- Labor cost
- Office expenses
- Mortgage interest accrued while you held the property (if you go through traditional financing)
- The home’s purchase price
- Materials cost
In addition, we always recommend you keep close track of your expenses. That way your accountant can accurately deduct your expenses from your gross profit and you only pay taxes on your net profit.
The Bottom Line
The taxes on flipping houses can be substantial. However, there are strategies available that lessen the tax consequences of flipping homes.
In addition to following our tax strategies for flipping houses, you should find the right people to advise you on taxes and anything else you may need to make your fix and flips a success. Experienced hard money lenders, real estate agents, contractors, and tax professionals, to name a few.
If you do, you’ll spend less time worrying about Uncle Sam and more time flipping properties for profit.