Entering the business of flipping houses sounds tempting, and you know many people who made money from it. Unfortunately, many new house flippers and real estate investors do not realize that there are taxes owed on the profit from flipping a property.
Actually, while the law requires paying taxes when flipping houses, there is no need to be wary of them. After all, taxes are a sign that you earned money in the process of flipping a house, which is excellent news.
But what are flipping taxes and how much tax do you pay when you flip a house? This is a question you should understand before starting your fix & flip project. In this article, we will provide a detailed overview of the applicable taxes when flipping a house. You will learn which taxes you are subject to and how to calculate how much you need to pay.
If you are fixing and flipping a property, you are subject to two basic flipping taxes:
Those who hold onto their property for less than a year will be subject to the ordinary income tax. If you hold onto the house for more than a year, then the long-term capital gains tax becomes applicable.
The general rule is that the long-term capital gain is lower than the ordinary income tax. However, you should always consult with a local professional because regulations might vary from one location to another. You can also check things you must know before investing in real estate.
Before we continue talking about the taxes, let’s discuss the actual term “ordinary income.” Let’s say that you enter a business of flipping a house.
It will involve the following steps:
Here is an example – let’s say that your basic income is $50K. You entered a project of flipping a house. After selling the property and paying everyone else, you calculated that the revenue from the project is $20K.
That means your total income will be:
$50K + $20K = $70K
Since this is an increased income, it might mean that you qualify for the next tax bracket, which will raise your tax rates.
The critical thing to note is that the IRS doesn’t see flipping houses as a passive investment. You are in the position of the investor, and any income you make on these transactions will be classified as “active.”
That means you are subject to standard income taxes on your net profits during the current financial year.
These are the three types of taxes you can expect for the ordinary income:
Here is an overview of the rates for the federal income tax brackets:
Any income made in less than 12 months is a short-term capital gain. However, if you hold possession for over 12 months before flipping it, you qualify for the tax to be calculated for a long-term capital gain.
Let’s take a look at different brackets for long-term capital gains tax:
In a huge majority of cases, a long-term capital gain is better for the investor. That is because the maximum taxation rate can’t go over 20%. The basic math tells you that it is more bearable than the potential 37% tax for the ordinary income. Additionally, the self-employment tax doesn’t apply anymore, although state taxes are still applicable.
The best way to show how to calculate taxes when flipping a house is by providing a few examples. We will consider tax calculation when you are subject to ordinary income or long-term capital gains tax.
You completed the house flipping project in less than 12 months. That means you will need to pay the ordinary income tax.
Project Details:
For the sake of the example, let’s say your income is $50K. If you add the $20K from the house flipping project, your total income is $70K. That puts you in the third tax bracket, with the rate set at 22%. The self-employment tax is always the same.
Make sure to check any potential state taxes, too.
Here is a different example if you held onto the property for over a year.
Project Details:
Self-employment tax isn’t applicable, which means you only need to calculate the long-term capital gain tax. You are in the bracket where the rate is 15%.
An excellent strategy to avoid (delay) paying taxes is to utilize the 1031 exchange. The strategy involves selling the property so that you don’t get any money for yourself. By performing this exchange, you don’t receive any actual income, but use the earned funds for flipping another property.
If you are interested in continuing the house flipping business, this could be a way to delay paying taxes and secure additional funds for future projects. Make sure to consult an expert on the topic first.
Here are some other tips for saving taxes when flipping a house:
There is no reason to be afraid of taxes when flipping a house. Always remember that you are paying taxes because you earned money, which indicates that house flipping was a success. Furthermore, a higher tax indicates that your income is higher, too, which is great news.
The only thing to ensure is that you understand how taxes work and come up with a strategy on how to pay the smallest amount possible. We hope our article provided some guidance, but don’t forget to consult a local professional.
Learn how you can make money flipping properties with us by attending our next webinar.