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Understanding Taxes on House-Flipping: Investment vs. Business

Flipping houses can be a lucrative venture, but understanding the tax implications is vital to maximizing your profit. Here’s a comprehensive look at how taxes affect house-flipping and the strategies you can use to reduce your tax burden.

When you flip a house, the IRS can treat your activity in two ways: as an investment or as a business. This distinction is crucial and primarily depends on your intent.

Investment Treatment

If your house-flipping is seen as an investment, you report it on Schedule D of your tax return. Here’s how that works:

  • Short-Term vs. Long-Term Capital Gains: If you hold the property for a year or less, the profit is taxed at short-term capital gains rates, which match your ordinary income tax rate. If you hold it longer than a year, it qualifies for long-term capital gains rates, typically around 15%.
  • No Self-Employment Tax: Investments aren’t subject to self-employment tax, which is an added 15.3%.
  • Basis Inclusions: All associated income and expenses are calculated into the property’s basis, meaning they’re recognized when you sell the property.

Business Treatment

If your flipping activity is considered a business, especially if you qualify as a broker-dealer, the properties are treated as inventory:

  • Self-Employment Tax: You’ll incur a 15.3% self-employment tax on your profits, significantly increasing your tax liability.
  • Income and Expenses: Reported on Schedule C within your personal tax return, or if your net income exceeds $50,000, it might be beneficial to opt for an S corporation to avoid self-employment tax after a reasonable salary has been paid.
  • Entity Structuring: Using separate entities for different activities can help determine intent and manage taxes. For example, separate entities for rentals and flips can frame your flips as capital-raising activities rather than a primary business focus.

Common Deductions

Understanding deductions can save you money whether flipping houses as a business or investment:

  • Auto Deduction: Choose between actual or standard mileage rates. For 2017, the standard rate is 53.5 cents per mile. Use apps like MileIQ to track your mileage.
  • Home Office Deduction: Deduct either actual expenses based on home office square footage or take the simplified $5 per square foot deduction, up to $1,500 annually.
  • Other Deductions: Include expenses like home insurance, interest, draw fees, repairs, professional fees, property taxes, and any ordinary business expenses.

Entity Choices for Tax Efficiency

Choosing the right business entity can offer both liability protection and tax savings:

  • LLCs: Flexible as they can be taxed as disregarded entities, partnerships, S corporations, or C corporations. They provide liability protection without significant tax differences unless structured specifically for tax advantages.
  • Partnerships: Great for holding property long-term and allowing special allocations of income and expenses between partners.
  • S Corporations: Effective for avoiding self-employment tax but not ideal for holding real estate long-term due to the lack of debt basis and inflexibility regarding special allocations.
  • C Corporations: Useful as management companies for converting personal expenses into business deductions and providing benefits like health insurance and retirement plans.

Advanced Strategies

Combining entity types can optimize your tax situation:

  • Series LLCs: Individual sub-series can limit liability while streamlining administration. For example, you can designate series for different types of investments, like rental properties, partnerships, and loans.
  • Management Companies: A C corporation can act as a management company, collecting fees and providing benefits, thereby converting personal expenses into deductible business expenses.

Practical Tips

  • Track Everything: Keep meticulous records of miles driven, costs, and time spent. Use tools that automate tracking to ensure accuracy and compliance.
  • Seek Professional Advice: Consult with a real estate-focused CPA to navigate the complexities of your specific situation. The right advice can save you time, money, and potential headaches from audits.

Takeaway

Flipping houses can indeed be a profitable venture, but understanding the tax implications is critical to optimizing your returns. Whether your activity is treated as an investment or a business by the IRS can significantly impact your tax liability. By strategically choosing the right business entity, leveraging common deductions, and employing advanced tax strategies, you can minimize your tax burden and maximize your profits. 

Always keep detailed records and seek professional advice to navigate the complexities of real estate taxation effectively. With the right approach, you can make your house-flipping ventures more financially rewarding.

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