House flipping is an expensive business, with many costs attached, including various taxes you must pay to keep going.
That’s why many entrepreneurs and house flippers use different house flipping tax deductions to make their endeavors more profitable while maintaining a legal approach.
If you’re one of those seeking a way of making their business more profitable using various tax deductions, this article will provide all the information you need!
- Who Are You, An Investor or a Dealer?
- House Flipping Tax Deductions
- Flipping Houses and Capital Gains Tax
- Full Breakdown of Your Taxes as a House Flipper
- How Can You Lower Your Tax Burden?
- Tax Breaks You Can’t Get as a House Flipper
- Frequently Asked Questions
- Wrapping Up
Who Are You, An Investor or a Dealer?
The first thing you need to clarify is your intention towards the property. Are you using it as an investment property looking for long-term capital gains, or are you just flipping it in a month or two?
If it’s a long-term investment, the IRS will consider you a real estate investor. In this case, you’ll have a whole different type of tax to pay, and you’ll probably need an accountant to cover all the aspects of the tax burden in the long run.
If you buy a property just to flip it, you’re a real estate dealer.
Here are some points that the IRS will use to determine if you’re a real estate dealer or not:
- The amount of real estate investments and their frequency. If you’re buying ten properties per month, you’re probably a flipper.
- The amount of improvements made and the initial state of the property.
- The amount of time the properties usually stay in your possession.
- How much advertising and promotion went into the property sales on your end.
In general, if you’re buying real estate just to improve it and sell for a profit, you’re a real estate dealer, and you have to pay different taxes.
House Flipping Tax Deductions
House flipping is a costly business with hundreds of varying outcomes. One of the biggest underlying costs when it comes to this real estate niche is the house flipping taxes, which can cut your profits significantly.
House flippers seek tax advice to lower their tax obligation at the end of the month. Unfortunately, most of the house flipping expenses aren’t immediately tax deductible. They should be, instead, capitalized into the base value of the property you’re buying.
Here’s a quick list of things you can include in the property’s original value:
- Indirect labor
- Direct labor
- The cost of the house itself
- Direct materials
- Production period interest
- Real estate taxes allocable to each project
When you sell the property, you can get a tax benefit from all these expenses and lower your taxable income, increasing your transaction’s profitability.
However, you should understand that these tax deductions can differ depending on the state you work in.
Flipping Houses and Capital Gains Tax
There are two types of capital gain taxes: short-term and long-term.
Short-term capital gains contribute to profits from assets that are held for less than a year and are taxed at the same rate as your regular income.
On the other hand, long-term capital gains tax is levied on assets kept for over a year. It offers a more favorable rate, varying from 0% to 20% based on your tax bracket.
For house flippers, we can only talk about short-term capital gains tax. It’s essential to realize that the longer you keep a house in your possession, the more it costs you. The goal is to buy, improve, and quickly sell the property. It’s even more urgent for you to seal the deal if a loan backs your investment.
Full Breakdown of Your Taxes as a House Flipper
We’ve now determined that the IRS categorizes house flippers as real estate dealers. This brings along additional tax implications you have to consider when planning your deal.
Not only will you have to pay personal income tax (which can reach up to 37% in some states), but you’ll also have to account for 15.3% in self-employment taxes.
Let’s use a simple example to illustrate the situation better.
If you are a real estate flipper with a yearly income of exactly $200,000, the federal income tax would amount to $40,811. Combine this with the self-employment tax of $30,600, and the total payable tax would be $71,411, which is 35.71% of $200,000.
This sum doesn’t contain any tax deductions you can possibly get from all your deals. In the next section, you’ll know some steps you can take to lower your tax bill at the end of the year.
How Can You Lower Your Tax Burden?
If you don’t want to give half your revenue just to pay taxes, you can take some steps to lower your tax burden. Here are some of the most important you can consider:
Form an LLC
Before diving into house flipping, set up a proper business foundation. The most popular form of an enterprise is an LLC or a Limited Liability Company.
LLCs offer the advantage of deducting business expenses and safeguarding your assets against a lawsuit or a legal claim.
Another appealing aspect of LLCs is their versatility. They can operate as a sole proprietorship, a partnership, or even align as a corporation.
But make sure to consult an attorney or an experienced person before setting up an LLC, as it’s a state-governed entity, and the rules of setting them up vary from state to state.
Use the LLC for Tax Deductions
As an LLC, you can write off different costs you’re using as business expenses. Here’s a list of those costs that can be categorized as business expenses:
- Legal and accounting fees
- Real estate commissions
- Travel expenses
- Office supplies
- Building permit costs
Make sure to only include fees you’re actually using to conduct business. A new trumpet for you or your kid can’t be deducted, and the IRS will most definitely punish you for including that in your tax break.
Report Capital Losses
As a businessman, you eventually have to accept that not every deal will be profitable. The good part about losing money, or as the finance guys say, losing capital, is that you can use the capital losses as a counterbalance for your capital gains.
However, before doing that, you should get some advice from your accountant or legal adviser.
Tax Breaks You Can’t Get as a House Flipper
There are some real estate tax breaks that you can’t use if you’re an active house flipper. Here are some of them:
This is a tax break related to your primary residence. It allows you to bypass capital gains tax on profits from selling your main home, up to a gain of $250,000.
To be clear, only houses designated as your primary residence are eligible.
To benefit from this exclusion, you must have resided in the property for a minimum of 24 out of the past 60 months. That’s why you can use this break for house flips.
This tax break enables investors to sell one investment property and postpone the associated taxes by purchasing another.
The IRS stipulates a 45-day window to pinpoint a suitable replacement property or 180 days to finalize the purchase.
But why can’t house flippers leverage this tax break? The IRS has strict guidelines about who can partake in a 1031 Exchange, expressly excluding properties acquired for resale.
Frequently Asked Questions
How Can I Avoid Paying Taxes on a House Flip?
It’s impossible to completely avoid paying taxes on a house flip as long as you do business legally. The only situation where you can avoid it is when you don’t have any capital gains or profits at the end of the year.
However, you can significantly lower your tax burden by completing all the steps described in this article.
You can also try and get a tax adviser if you’ve already passed $1,000,000 in yearly revenue. That’s where you can start reinvesting a part of the profit, set up different accounts, or even transfer a portion of your money overseas.
Can You Take Depreciation on a House Flip?
Rental real estate property owners can deduct a non-cash expense known as depreciation.
However, this doesn’t apply to house flippers. In the house flipping business, homes aren’t viewed as investment properties but as inventory, and inventory doesn’t undergo depreciation.
Do You Have to Pay Taxes in the Flipping Industry?
The state taxes every activity that brings in profit or revenue. If you have an income, be it from a flip, an investment, or a sold item, you must pay taxes.
This perspective might not be widely embraced here, but if you’re frequently flipping items, reporting that income for taxation is essential.
There you have it, a full guide on house flipping tax deductions. You can use it to make your business plan more detailed, calculate all the expenses, and include the deductible expenses.
However, keep in mind that no article online will be able to give you the full picture. That’s why, if your business is expanding, you should hire an accountant who’ll help assess your financial situation.
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