The state laws recognize what you do as a business the moment you move from merely flipping houses once or twice to consistently doing it. This will mean reporting your profits to the IRS.
If you’re interested in learning how to report flipping a house on tax return, you’ll find this guide a reliable resource.
Here, you’ll learn more about what qualifies you to report taxes. We also explain how you can reduce your house-flipping tax returns and save more money.
Real Estate Tax Issues: Reporting House Flipping Tax
Real estate investors are subject to several types of taxes. However, these taxes are classified based on their supposed intent and activities.
Before reporting house flipping taxes, it’s best to understand what category a taxpayer falls into based on their intent and activities.
This will help determine how the taxes are filled—capital gains tax or ordinary income—and their benefits.
Real Estate Dealers
Under the IRS, a dealer is an entity that buys and sells real estate in the ordinary course of their trade or business. These include wholesalers, developers, and house flippers whose primary goal is to sell a property immediately after renovating it.
To be clear, qualifications for the IRS dealer status don’t depend on the number of homes you sell in a given period but on your intent.
Thus, you can sell more homes in a given time and still pay taxes as an investor (more on this later.)
Besides intent, one can acquire a dealer status if they:
- Hold properties short-term
- Make extensive home improvements
- Invest more resources and energy into marketing and sales of the property
- Generate an income on sales that makes a significant share of the total investment
Dealer Tax Commitment
Real estate under the dealer status is treated as inventory, not capital assets. Your gains or losses aren’t classified as capital gains but are reported as ordinary taxable income and subject to self-employment tax.
Generally, the tax implications for ordinary income tax can go as high as 37% of the generated profits. There’s also an effective rate of 14.13% owed as self-employment taxes. All of these go without the eligibility to depreciate properties and defer taxes.
While these might seem like a disadvantage for dealers, there are still upsides to falling into this category.
For one, dealers can list their business expenses as regular business deductions. These expenses could include fees like marketing, legal, and accounting.
The IRS also allows dealers to deduct losses during business as a normal business loss without limit. In other words, a dealer can deduct all their year’s loss from their tax payments.
However, it’s worth noting that while getting a license isn’t necessary for house flipping, establishing your business as a legal entity can qualify you to list more deductible expenses.
Real Estate Investors
Some house flippers might want to take advantage of the investor status benefit, like avoiding self-employment tax. For instance, instead of buying a house and flipping it immediately, they hold it for a longer period before selling.
Generally, the IRS considers taxpayers who buy property for appreciation or rent as investors.
Besides this intent, you can become an investor if you inherited the property or spend less time in the sales process—it’s the opposite of being a dealer.
Investor Tax Commitment
The upside to having investor status is more desirable. For instance, you’re qualified to file a 121 exclusion. It’s a provision in the tax code that allows homeowners (or investors in this case) to deduct up to $250,000 (or $500,000 as married couples) from their taxes.
However, there are conditions to fulfill. The taxpayer must have lived in the house for two out of the last five years (not consecutively) before filing for a deduction.
In other words, you can rent the property for three years, live in it for two years (within five years), and still claim at least $250,000.
There’s also a provision for a 1031 exchange for investors: the tax-deferred exchange. This allows taxpayers to take the profits from property sales and invest them into another. The catch here is to defer the capital gains tax.
Like every tax benefit, there are rules regarding how you can claim them. For a 1031 exchange, the properties must be “like kind.”
According to the IRS, like-kind properties are two similar properties of a similar nature. For instance, investors can exchange a hotel for a retail property or an apartment building for a shopping center.
The general rule is that the property in exchange must not be a private residence. Only properties used for business and investment purposes qualify for a 1031 exchange.
Tax Difference Between a Dealer and an Investor
Dealers pay more taxes on property sales than investors. Although a dealer can get slightly more benefits, assuming they contract an experienced CPA, they’ll still pay income and self-employment taxes.
An investor, on the other hand, holds the properties for a long time, qualifying them to pay a capital gains tax (instead of an ordinary income tax).
And capital gains tax is only about 10% to 20% of the profit on property sales. Besides this, they enjoy other benefits from 121 exclusion to a 1031 exchange, as discussed.
One other clear difference is where dealers and investors report taxes. While a dealer will report on Schedule C, an investor will report on Schedule D of the Federal Form 1040.
Here’s an example to illustrate a dealer and an investor’s tax expectations on a $200,000 property sales gain:
|Real Estate Dealer||Real Estate Investor|
|Income tax max, 37% = $74,000||Long-term capital gains max, 20% = $40,000|
|Self-employment tax, 14.13% = $28,260||No self-employment tax|
|Total estimated tax due = $102,260||Total estimated tax due = $40,000|
Tips to Help Reduce House Flipping Tax
Taxes can be a bit high, especially when you’re a dealer. However, professional flippers who understand how the taxpayers’ system works use several methods to reduce their tax due.
These are some of the methods:
Avoid Filing Tax Incorrectly
You’ll often see most newbie house flippers make this mistake whenever they enter their tax for the first time. The issue is that they often think that all taxes on house flipping are billed as capital gains, but this mistake can end up costing them.
As we’ve explained, the IRS bills real estate taxpayers based on intent. That’s why if a dealer (who regularly flips houses for profit) records their taxes as capital gains instead of regular income taxes, they might be penalized.
Avoiding this error alone can save you a chunk of your profit.
Earning Income Through Corporation
This tip particularly suits those who handle large flipping projects. The bigger a project is, the larger the risks.
House flippers can undertake corporate insurance rather than homeowner insurance to reduce risks. This coverage separates your business as a legal entity.
But here’s how this affects your tax. Earning income inside a corporation isn’t considered an ordinary income but an active business income. This reduces your tax from as high as 55% to 12.2%.
Moving Into the Property
Moving into a property you flipped is a common strategy investors aim to use to reduce taxes, yet it’s a widely misunderstood concept.
While it sounds easy, it’s not as simple as moving into the property for a few weeks and then selling it to a ready buyer. The goal is to prove your intent as an investor and then get reduced taxes through long-term capital gains.
You’ll need to move into the property as your residence for at least two years to achieve this. With this method, you can save up to 15% on taxes.
Learning to report taxes on your house flipping business is as important as running your business operations. Any slight mistake can cost you a lot in penalty fees.
If you have little or no experience reporting taxes, especially in the U.S., the best thing to do is contact a reliable CPA.
You can also reach out to us in the comment section if you have questions; we’ll be willing to shed more light on the subject. And please share this article with someone who’ll find it valuable. Good luck!