Flipping houses offers the potential for quick profits, but those profits come with tax implications that every house flipper must understand. The way your earnings are taxed depends on factors like your total income, business structure, property holding time, and where the house is sold.
Understanding and managing your tax liability significantly impacts your overall profitability. By learning about the different taxes involved and implementing effective tax strategies, you can safeguard your net profit and keep your business financially healthy.
Ordinary Income Tax vs. Capital Gains Tax
Most house flippers, even the part-timers, hold properties for less than a year, meaning they’ll likely face short-term capital gains tax rates. Under short-term capital gains, your net profits are taxed as ordinary income, meaning they’re subject to the same federal income tax rates as wages or salaries. Depending on your tax bracket, the ordinary income tax rate ranges from 10% to 37% in 2024.
On the other hand, if the property is held for more than a year, you might qualify for long-term capital gains tax rates. In 2024, these rates range from 0% to 20% of your net profits.
Self-Employment Tax
House flippers are typically considered real estate dealers by the IRS and must pay self-employment tax. Self-employment taxes add a 15.3% tax on your profits (up to $168,600 in 2024) to cover your Social Security and Medicare taxes. However, if the flipped house qualifies for the long-term capital gains tax rate, then you don’t pay self-employment tax on the profits.
Taxes on Flipping Houses Vary by State
In addition to federal income taxes, house flippers must also account for state income taxes. These taxes vary significantly by state, with some states like Florida having no state income tax, while others impose rates as high as 13.3%, as in California. This means that where you flip houses can have a major impact on your overall tax obligation.
Additionally, some states impose state capital gains taxes, which can affect your profits. Local property taxes are also a factor, typically applied annually by the city, county, or state.
It’s important to understand both federal and state tax laws when planning a house-flipping project, and this is where partnering with an experienced real estate CPA, like Alpine Mar, becomes invaluable. An experienced CPA can help you navigate state-specific taxes and laws and ensure you’re compliant with both federal and state regulations.
When Are House-Flipping Taxes Due?
For a house flipper, houses are treated as inventory, and project costs are categorized as the cost of goods sold. Income taxes are not incurred on these ‘goods’ until they are sold. For instance, if you purchase and renovate a house in 2024 but sell it in 2025, you would report and pay income taxes on the profits in 2025.
Sole proprietors, partnerships, and S corps shareholders are required to report their net profits and pay estimated taxes on a quarterly basis using IRS Form 1040-ES. Payments are due on, or the first business day after, the 15th of April, June, September, and January of the following year.
Strategies to Minimize Your Taxes on Flipping Houses
House flippers should consider various strategies to reduce their house flipping taxes, especially given the significant tax burden of flipping multiple properties in a single year.
Establish an LLC With an S Corp Tax Designation
One way to reduce self-employment taxes is by establishing an LLC for your house-flipping business and electing to be taxed as an S corporation (S corp). This setup allows you to pay yourself a reasonable salary, with the remaining profits distributed as dividends, which helps lower the portion of income subject to self-employment taxes. Consulting a CPA will help you identify the best business structure for your real estate investing business to help lower your overall tax obligations.
Simple Example of How Much Tax You Can Save as an S Corp
Let’s say you’re in the 32% federal tax bracket. You purchased a house in Florida in February for $300,000 and renovated it for $75,000. It was sold in August of the same year for $500,000, resulting in a gross profit of $125,000.
Sole Proprietor
As a sole proprietor, the $125,000 profit is taxed as ordinary income on your personal tax return. With a 32% tax bracket, this results in an income tax liability of $40,000. Additionally, self-employment tax on the profit would be approximately $19,125, leading to a total tax obligation of around $59,125.
LLC With an S Corp Designation
Let’s say you were trading as an LLC with an S corp tax designation and you take a $25,000 annual salary. This salary is taxed as ordinary income, resulting in approximately $10,000 in income and payroll taxes.
The remaining $100,000 profit is distributed as dividends—not subject to self-employment tax—but taxed at the 32% rate, leading to $32,000 in income tax. Overall, your total tax obligation is approximately $42,000.
Flip Your Own House
The most reliable way to avoid paying taxes on house-flipping profits is to live in the property as your primary residence for at least two years. This allows you to exclude up to $250,000 of the gain from taxes ($500,000 for married couples filing jointly) when you sell the home.
Tax Deductions for House Flippers
Another way to reduce your taxes when flipping houses is by carefully tracking all your business-related expenses. Certain costs may be eligible for immediate deductions from your taxable income. These include expenses like office rent and utilities, loan interest, legal and accounting fees, and business-related travel costs.
Capitalized costs, which can be deducted when the property is sold, include the purchase price and closing costs, renovation materials and labor, utilities, equipment depreciation, insurance, and real estate taxes. It’s important to consult with an experienced CPA to determine which expenses are eligible for immediate deduction and which must be capitalized.
Deferring Capital Gains Taxes
A popular and effective tax planning strategy is to defer capital gains taxes by using a 1031 exchange or a reverse 1031 exchange. This IRS rule allows real estate investors to defer when they pay taxes by reinvesting the proceeds from a property sale into another ‘like-kind’ investment property.
However, real estate dealers—those in the business of flipping properties for profit—typically don’t qualify for 1031 exchanges if the property is considered inventory or held primarily for sale. However, in some cases, if a dealer decides to rent out the property for a period of time, they may qualify for a 1031 exchange. To use this tax deferral, you must understand and adhere to strict IRS rules regarding your intent, the timing of the sale, and the type of replacement property selected.
Depreciation Deductions
Although depreciation deductions primarily apply to rental properties, there may be instances where house flippers can take advantage of these tax benefits. If you rent out a property before selling it, you might be able to claim depreciation deductions, which can help reduce your taxable income.
This strategy requires a deep understanding of IRS rules—as it can lead to depreciation recapture—and should be discussed with a tax professional to ensure compliance.
The Importance of Professional Tax Advice
Flipping houses can be a lucrative venture. However, understanding and managing the tax consequences is crucial to maximizing your profits. Given the complexity of the IRS Tax Code related to flipping houses, working with a CPA who specializes in real estate investing and tax planning services is the best approach to ensure you’re minimizing your tax liability. They will help you understand which deductions apply to your specific situation and how to structure your house-flipping business in a tax-efficient way.
Whether you’re a full-time house flipper or someone flipping an occasional property, getting tax advice early in the process can save you from significant tax implications down the road. It’s essential to stay compliant with federal and state tax laws to avoid penalties and ensure smooth operations in your house-flipping endeavors. With professional guidance, you can navigate the intricate tax landscape, optimize your financial strategy, and focus on growing your business.
