The real estate market has certainly bounced back from the crash in 2008. Prices have surged over the past few years and continue to steadily climb, causing many experts to anticipate a recession in the real estate market in the near future. For real estate investors, this marks a great time to consider (or continue) flipping houses, given the hot seller’s market.
But before you turn on HGTV and dive head first into a fix & flip, you must be aware of the silent partner you’re taking on in this venture… Uncle Sam. There are two ways the profit made from flipping a house could be treated by the IRS: ordinary income or capital gain. Before we go any further, let’s make sure the general difference between the two (relating to flips) is understood:
|At what rate is the profit taxed?||Your ordinary tax rate, based on your income level||ST (held for less than one year) – your ordinary rate + 3.8% net investment income tax
LT (held for one year or longer) – 20% + 3.8% net investment income tax
|Subject to self-employment tax?||Yes||No|
|Where is income reported?*||Form 1040 – Schedule C||Form 1040 – Schedule D|
* This assumes the taxpayer completed the flip as an individual, not via an incorporated entity (LLC, partnership, corporation, etc.)
As you can see, the difference in classification could materially affect the amount of cash going into your pocket after a flip. It is critical to understand how your profits will be taxed in order to properly budget and make sure you don’t end up losing money after your property is sold.
But how do you know which income classification your flip falls under? Unfortunately, there’s no hard and fast rule defined by the IRS, but they do provide us with some general guidelines. Let’s break it down into three categories:
1. Primary residence
You buy a home, live in it during the fix-up process, and then sell it. In this case, you are technically buying the property as a resident first and an investor second. Any profits are treated as a capital gain and taxed at preferential rates (see table above).
You can reduce/eliminate the capital gains tax when selling your primary residence if you meet the ownership and use tests. If you’ve owned (ownership test) and lived in (use test) the property for at least two out of the five years prior to the date of sale, you can exclude up to $250,000 ($500,000 if you’re married) of the gain from your income! This doesn’t have to be two consecutive years.
You purchase one property (or one property every so often) with no intention of moving in, fix it, and flip it. In this instance, you are buying the property as an investor, but it is not a regular and routine form of business. Profits are treated as a capital gain in this scenario, too.
The major difference between this and #1 is that you cannot exclude any portion of the gain from your income since you would not pass the use test.
3. Business or trade
You purchase, fix, and flip multiple properties on a routine basis as your primary form of business. In this scenario, flipping real estate is your main form of income and profits are therefore treated as ordinary income and taxed at your ordinary tax rate. This income is also subject to self-employment tax (FICA and Medicare), which tacks on another 15.3% in taxes (you can deduct half of this tax as an adjustment to your income to reflect the “employer’s share” of the tax).
The problem is, there is no set number to determine how many flips render you as a “professional” flipper. It’s not as easy as saying, “if you flip five or more homes per year, you must treat the profits as ordinary income.” It’s case-by-case; the IRS analyzes your specific situation to determine whether or not you’re running a business.
If you’re flipping a few homes per month, it’s safe to say you’re probably going to be considered as conducting a business or trade in the form of flipping houses. If you flip one home per year, it will be easier to label you as an investor who doesn’t flip houses on a regular basis.
Here is a quick summary of the above three categories and how the profits generated from each will likely be taxed:
|Flipping a primary residence||
|Investor who completes infrequent and sporadic flips||
|Professional who is “in the business” of flipping homes||
Option to defer taxes
Under IRC Section 1031, taxes on the gain from the sale of a business or investment property can be deferred if the proceeds from the sale are used to buy another property that is similar in nature to the one just sold. This is strictly for investment and business properties, so personal residences (including vacation and second homes) are excluded from this opportunity (but the capital gain exclusion on personal residences evens the playing field).
Keep in mind that this does not exempt you from paying taxes on the gain, it just defers it and rolls it into the next property. To learn more about Section 1031 exchanges, click here.
If you want to continue the conversation, leave a comment below or reach out to me. I’m a real estate nerd and could talk about it all day.
The photo used for the featured image of this blog post is by backkratze [CC BY 2.0], via Wikimedia Commons
Nick Aiola is a CPA located in New York, NY. Nick provides tax and accounting services to a wide range of clients, including individuals, businesses, and fiduciary entities.
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