Many people have ventured into house flipping because of the lure of quick cash. People from all walks of life have been enticed to buy houses for the purpose of reselling them at a profit. If done right, it can work and there is a decent profit to be had. However, prospective investors need to be aware of the tax consequences of flipping houses. Taxes can take a hefty bite out of any profit derived from flipping.
Understanding the tax laws that govern the purchase and sale of flips will help an investor develop tax strategies that can reduce tax liability and personal liability. Below are some house flipping scenarios and the corresponding tax consequences.
House Flipping as a Business
If you complete several house flipping transactions in a short time and will continue to do so well into the future, the Internal Revenues Services (IRS) will consider your transactions as a business or trade rather than as an investment strategy. In that case, you will be subject to state income taxes, federal income taxes and self-employment taxes. The self-employment tax is 15.3%. Federal income tax rates can be as high as 35%. State income taxes vary form state to state while other states have none.
Holding Onto the Flip for More Than a Year
Investment profit from the sale of a real estate is considered capital gain and is taxed at two levels depending on how long you own the property. When you hold onto the flip for a year or less, you face short-term gain that is taxed at ordinary tax rates that can go as high as 35%. By holding the flip for more than a year, your gain is treated as a long-term profit and is taxed at more favorable rates. In most instances, capital gain rate maxes out at 15%.
1031 Exchange (Like-Kind Exchange)
If you hold on to a flip for at least a year, you may be able to exchange the property for a like-kind property thru a 1031 exchange. In a 1031 exchange also known as a like-kind exchange, a person who sells a property can defer payment of capital gain taxes by immediately rolling the gains into the purchase of one or more like-kind investment properties. The exchanged property cannot be a personal residence or second home. No gains get paid to you. You cannot take possession of the money from the sale. The money is held in escrow or held by a qualified intermediary such as a trust company until the replacement property is acquired. You have 45 days to identify a replacement property and 180 days to close on the replacement property or properties. If you are considering a 1031 exchange, consult with a competent lawyer as the rules governing 1031 exchange can be complicated.
Personal Residence
You can move into an investment property and turn it into your personal residence. As long as you live there for 2 out of the last 5 years ending on the date that the property is sold, you can avail of the special tax exclusion. If you are single, you do not have to pay taxes on the gains, a maximum of $250,000, from the sale of your personal residence. Married couples can make $500,000 in profits and still pay no taxes on the sale of their primary residence. However, if you sell your personal residence in less than 2 years, you may still qualify for partial tax exclusion but only if you sell your property as a consequence of a change in your place of employment, health reasons, death, divorce and other unforeseen circumstances.
In a nutshell, do not let taxes deter you from venturing into house
flipping. There are legal ways to minimize and even in some cases do away with paying taxes.
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