Do you want to enter the lucrative world of home flipping? This type of real estate investment can provide quick returns and a constant supply of new capital. But it faces some unique tax challenges. Here's what you need to know about the biggest differences between flipping and other real estate investments.
What Makes Flipped Homes Different?
It's first important to understand the differences between investment, resale, and a trade or business. A property held for investment is owned for the profit from future appreciation. One that is held for use in trade or business produces income while you own it (such as a rental). Property that is held for resale, on the other hand, is like inventory in a retail business. You buy it specifically to sell soon afterward.
Flipping homes is generally considered holding property for resale. This definition makes a big difference in how profits are treated by the IRS.
How Does Property Held for Resale Affect Taxes?
Flipping homes held for resale has several major consequences for your tax bill. Here are three of the most important.
It's Taxed as Ordinary Income
Most forms of profit from real estate sales are considered a capital gain and taxed at a lower rate than your other sources of income. However, profits made from property held for resale are considered ordinary income and taxed at the same rate as your other sources of income. And, as a self-employed person selling inventory, that income may also be subject to self-employment tax.
Many Expenses Are Capitalized
Businesses generally can lower their taxable income by using tax deductions for their costs of doing business. While some deductions are available to flippers — such as advertising, travel costs, or general tools and equipment — many others must be capitalized into the base cost of each home in question. This includes direct labor and supplies, insurance, taxes, utilities, and fees. You cannot use these to reduce your business income in the same way.
Like-Kind Exchanges Aren't Allowed
Real estate investors often rely on like-kind exchanges to defer taxes on their profits. But because flipped homes are considered inventory rather than investments, this special election doesn't apply to flippers' sales.
How Can You Plan for Taxes When Flipping?
Because flipping is so unlike traditional real estate investment, tax planning is even more important. Begin by consulting with a tax preparation service in your state. They will help you determine the tax consequences of each sale and learn how to legitimately avoid unnecessary taxation. Call today to make an appointment.