Top 5 Differences in Investment Property Tax Deductions for Fix and Flippers
About the author: Thomas Castelli, CPA is a tax strategist and real estate investor that helps other investors keep more of their hard-earned dollars in their pockets and out of the government’s.
Venturing into house flipping can be an extremely profitable endeavor, as well as a rewarding experience. You have the opportunity to run and manage projects that could better a neighborhood and create a place for families to call home and make memories in. Not to mention, it can catapult you into financial freedom.
However, like anything worth taking a risk for, there are important things to understand and research. So make sure you are wisely investing and ingesting the full scope of the tax implications that come with flipping houses. As a fix and flipper, it’s crucial to grasp that your profits most likely won’t receive the same investment property tax deductions.
Did you know that serious house flippers are considered dealers of real estate and not investors, according to tax law? Dealers are in the business of buying properties with the intention of reselling them rather than holding them for rent (just like a car dealer purchases a cars for resale). Dealers are subject to the 15.3% self-employment tax, and miss out on many of the same tax benefits and investment property deductions that other real estate investors enjoy.
Unfortunately, there is no one particular factor that determines whether or not one is considered a dealer or an investor and one should refer to their accountant to obtain professional tax advice. However, generally if you’re flipping more than two to three properties per year, then chances are you may be considered a dealer.
In this article, we’ll discuss some of the key differences in tax treatment between dealers and investors, as well as what you can do to mitigate your exposure to the self-employment tax as a dealer.
Fix and flip profits are NOT taxed as capital gains
Unlike an investment property that you hold for rent, when you sell a fix-and-flip property, the profits are considered ordinary income and NOT capital gains. This is a key distinction when making profit projections because capital gains are taxed at a rate of 15-20%, while ordinary income is taxed at ordinary income rates of up to 37%.
Let’s say you buy a property for $100,000 with an after-repair value (ARV) of $140,000 after putting $20,000 worth of work into it. If this were a long-term investment property, you would pay 15-20% in capital gains tax on the $20,000 of profit. This comes out to be $3,000-$4,000 in taxes. Compare that to a fix and flip, you would pay $4,400-$7,650 in taxes assuming you’re in the 22%-37% tax brackets.
The self-employment tax and how to mitigate it
In addition to paying tax at ordinary tax rates, you’re subject to the 15.3% self-employment tax on your earnings up to $132,900. That’s up to $20,334 in additional taxes—ouch!
The good news is, as a flipper, you can reduce your exposure to this tax using an S-Corporation (or an LLC taxed as an S-Corp). S-Corporations allow you to pay yourself a wage, and only the portion of your profits considered wages are subject to the self-employment tax. While the remaining profit is considered a shareholder distribution, which is not subject to the self-employment tax. Thus, the goal is to classify as much of your profits as shareholder distributions as possible to reduce your exposure to the 15.3% tax.
That being said, the wage you pay yourself must be reasonable for your role in your business, and you’ll want to work with an experienced tax adviser to find out what that amount should be for you.
Let’s assume your net profit on your flipping business is $120,000 for the year. Simply reporting this income on Schedule C of your tax return will expose you to $15,300 in self-employment taxes. But if you had used an S-Corporation instead and paid yourself a wage of $55,000, you would have saved yourself $9,945 in taxes.
Bonus: Fix and flippers have to pay tax upfront on installment sales
A popular strategy for real estate investors is to buy a home, fix it up, then sell it to an end buyer using seller financing, also known as an installment sale.
When a property investor uses a seller financing, they act as the bank and provide a loan to the end buyer. The end buyer makes monthly payments over a predetermined number of years.
For investors, this is great because the seller will only pay the capital gains tax as they receive payments. This breaks down the capital gain over several years, rather than having to make a big tax payment upfront when the property is sold.
However for dealers, the tax treatment when using seller financing isn’t as attractive. While you can still use an installment sale, all the tax is due upfront and is not spread out over multiple years. This can be a problem because even though the tax is due, you haven’t yet received full sales proceeds from the buyer.
That said, it is important to understand this distinction if you’re considered a dealer.
The bottom line
If you’re a fix-and-flipper or decide it’s the right investment strategy for your business, it is important to understand that you’re operating an active business and are not exactly seen in the eyes of the IRS as an investor, but rather a dealer. Dealers of real estate don’t receive many of the investment property tax deductions and benefits that traditional investors do. In addition, dealers are subject to the 15.3% self-employment tax on your earnings, and they are not considered capital gains. The good news is however, you can mitigate your exposure the self-employment tax by using an S-Corp.
By having a full grasp of the fix-and-flipping tax technicalities, you can turn your fix-and-flip business into a profitable one. LendingHome is one of those partners that can support you in the process of scaling your business. By offering funding for up to 90% of the purchase price and up to 125% of the rehabilitation fee with holdback, our partnership puts better opportunity in your hands.
Want to learn more?
Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. Please consult your tax advisor. All calculations and information shown here are for illustrative purposes only. All third parties listed above are for demonstration purposes only and are not affiliated with LendingHome. All views and opinions expressed in this post are the author’s own and not of LendingHome. NMLS ID: 1125207 Terms, Privacy & Disclosures. Copyright LendingHome Corporation 2019.