Now that year-end is behind us, we’ve got taxes on our mind, specifically, the tax treatment of house flippers. “If you’re paying taxes, that means you’re making money” – so goes the old adage and it is true. But, while true, nobody wants to pay Uncle Sam more than they need to…and some clever tax-planning upfront may help you keep more of your hard-earned profits. Whether you are an experienced builder or flipper, or are considering a fix and flip investment, the tax treatment of your projects is paramount to your bottom line.
When it comes to real estate investments that are dependent upon a sale in relatively short order, it’s important to understand several distinctions and how they affect your tax obligations. Without getting too taxing (sorry, couldn’t resist) let’s DIG in with some valuable insights that are not to be taken as tax advice.
Capital Gains Vs. Ordinary Income
Why don’t we start at the end? How much will you have to pay? Well, it’s more complicated than this, but you will either pay capital gains tax, or ordinary income tax. It is almost always more advantageous to pay long term capital gains tax, which means that you held the capital asset for more than one year, before selling it.
Long term capital gains are typically taxed at either 15% or 20%. Short term capital gains, when the asset was held for less than one year, are taxed at your ordinary income rate, which is usually going to be higher, and can reach 37%. However, when it comes to home flipping, the holding period is not the only factor that determines whether you pay capital gains or ordinary income, we will address the other key factor in the next section.
Investor Vs. Dealer/Trader
One other key factor in determining the tax treatment of house flippers is whether you get defined as a real estate trader, or a “mere” investor. A “real estate trader” according to the law (to be precise, as defined in Treasury Regulation §1.1402(a)-(4)(a)) is “an individual who is engaged in the business of selling real estate to customers.” Regardless of whether a dealer/trader holds the asset for more than one year or not, their profits are taxed as ordinary income. That can be pricey, from a tax point of view. To add insult to injury, they must pay up to 14.13% in self employment taxes. That’s quite a bit!
It is important to note that this does not apply to real estate investors focused on “buy and hold” strategies. Rental income is considered passive income, while income from flips and property sales is often considered active. This is why dealer/traders are subject to the higher rates.
On the FLIP side, if you can avoid being characterized as a dealer/trader by the IRS, you fall under the category of an “investor”. Besides sounding flattering, being an investor is a great thing, as investors can still sell their properties at a profit and pay capital gains tax. Additionally, investors can utilize 1031 exchanges to continue to defer taxable income and roll it into new investments. A 1031 exchange is when an investor takes the profits from one real estate sale and uses them to purchase a new property.
While the label of “investor”-hood is bedazzling, unfortunately, how you capture that sparkle isn’t as clear. While a definition exists, there is no clear distinction related to deal volume or portfolio size as to when the IRS will define someone as a dealer/trader. This is where a really good real-estate-minded tax advisor comes in handy.
So what now?
Ultimately, it is clear that the tax treatment of house flippers is not black and white. It is also very clear that flippers and builders are best off being careful about the activities and income that can be attributed to their work as dealer/traders. It is beyond the scope of this piece to address the strategies for avoiding or minimizing dealer status and the income that needs to be reported.
However, tips and tricks do exist – ranging from categorizing expenses the right way, to incorporating strategically, to taking the appropriate deductions – and your qualified tax advisor can help you find the best strategy to minimize your exposure. No matter if you are flipping houses, buying and holding or anything in between, you should always plan for and be aware of your tax obligations prior to undertaking any real estate investment project.
Whether you qualify as an investor or a dealer/trader – you can finance your project or projects with Diggifi. Check out www.diggifi.com or download the Diggifi app in the app store or google play and get DIGGING.