On any list of the advantages of real estate investing, you’re sure to find tax benefits. G. Brian Davis, co-founder of SparkRental.com, takes you through 5 of them.
About the author: G. Brian Davis is a real estate investor who has owned dozens of investment properties over the last 15 years. He’s also the co-founder of SparkRental.com, an online resource which provides free landlord education and video series for anyone looking to build passive income from rentals.
On any list of the advantages of real estate investing, you’re sure to find tax benefits.
Expenses such as maintenance expenses, mortgage interest, and management fees are tax-deductible, plus many paper expenses like depreciation and the new pass-through deduction. In addition, real estate investors can take advantage of opportunities in the tax code that favor landlords, allowing them maximize their tax benefits and minimize their tax liability.
Ready to master the world of house flipping tax benefits?
Overview: House flipping taxes vs. long-term rental taxes
If you own an investment – any investment, whether real estate, stocks, or a 1962 Aston Martin – for less than a year and then sell it for a profit, the IRS classifies that profit as normal income and taxes it at your standard tax rate.
In this case, the IRS considers you a “dealer,” someone who buys something, perhaps improves it, and then resells it for a profit. Thus, a real estate investor is no different than a vintage car restorer or antiques dealer in the eyes of Uncle Sam.
You may not think of yourself as being “in business” because you may work an unrelated full-time job and flip houses as a side project to bring extra cash. But real estate investing is a business like any other, whether you buy properties under an LLC or in your personal name. And the more you operate like a business, complete with a real estate investing business plan, the more likely you are to be profitable.
Uncle Sam views landlords differently. They are not “dealers” like house flippers are. Instead they are considered long-term investors, who are granted preferential tax treatment.
Short-term vs. long-term capital gains
Own a property for 11 months, and sell it for a profit? That profit is classified as a short-term capital gain, taxed at your ordinary income tax rate.
Own the same property for 13 months? Your profit has transformed from a short-term to a long-term capital gain, because you owned the investment for more than a year.
Why does that matter? What’s the difference?
It’s an enormous difference, actually. The long-term capital gains tax on flipping houses owned longer than a year is between 0-20%. Most middle-class taxpayers can expect to pay a 15% tax rate on long-term capital gains. This is far less than what house flippers must pay if they’re taxed as dealers.
How are house flipping taxes typically calculated?
As outlined above, income from flipping houses that you’ve owned for less than 365 days is classified as short-term capital gains and taxed at your normal income tax rate. Federal income tax rates currently range from 10-37% of your income, depending on your tax bracket. Those brackets are as follows:
|Individuals||Married Filing Jointly||Normal Tax Rate||Long-Term Capital Gains Rate|
|Up to $9,525||Up to $19,050||10%||0%|
|$9,526 to $38,700||$19,051 to $77,400||12%||0%|
|38,701 to $82,500||$77,401 to $165,000||22%||15%|
|$82,501 to $157,500||$165,001 to $315,000||24%||15%|
|$157,501 to $200,000||$315,001 to $400,000||32%||15%|
|$200,001 to $500,000||$400,001 to $600,000||35%||15%|
|over $500,000||over $600,000||37%||20%|
For the sake of comparison, to the right you’ll notice just how much lower the long-term capital gains tax rate is. While flipping houses taxes are high, the tax challenges don’t end there for flippers.
Anyone classified as being in business – which house flippers generally are, as dealers – must pay double FICA taxes (Social Security, Medicare, and Medicaid taxes). If you work a day job, you’re familiar with the employee side of FICA payroll taxes, carving 7.65% away from your paycheck every two weeks.
Did you know that’s only half of your FICA tax bill, and your employer pays the other half?
It’s a bitter pill that business owners and the self-employed know only too well. They have to swallow both sides of FICA taxes, totaling 15.3%.
That’s on top of normal federal income taxes. Thus, the combined total of Federal income and FICA taxes as a house flipper is 25.3% to 52.3%, for flippers who own their properties for less than a year.
With that said, if you only flip one, maybe two houses a year, your accountant may be able to make a case that you are not “in business” and should be classified as a dealer for tax purposes. You’ll still need to pay short-term capital gains tax at normal income tax rates, but you could then avoid the double FICA taxes. That’s a conversation filled with legal gray area, best had with your accountant.
As a final note, long-term capital gains are not subject to FICA taxes, saving the hassle of the above requirements.
State & local taxes
In addition to federal income taxes and FICA taxes, house flippers must also pay state and local income taxes on their profits.
For example, real estate investors in Baltimore City, Maryland must add on another 8% to their tax liability. That breaks down to the 5% Maryland income tax, plus 3% Baltimore City income tax.
Think you’ll avoid state income taxes, by living in an income-tax-free state and investing in states with income taxes? Think again. States that impose income taxes typically withhold taxes at settlement from out-of-state sellers.
Continuing the example above, a Baltimore City real estate investor can expect to pay between 33.3% to 60.3% of their income in combined Federal, state and local income taxes and FICA taxes.
Note that most states that charge income taxes do charge long-term capital gains as regular income.
Flipping houses taxes: an example
You find a good deal on a house to flip. You’ve negotiated a $50,000 purchase price, estimate about $30,000 in repair costs, plus around $10,000 in soft costs. By your estimate, you think the property should sell for around $115,000.
Slam dunk deal, right? It may well be a good deal. But you won’t actually walk away with the projected profit of $25,000 (= $115,000 Sales Price – $50,000 Purchase Price – $30,000 Soft Costs).
Consider these sample numbers:
|Loan origination and points||$1,200|
|Purchase closing costs||$800|
|Interest on your bridge loan||$300|
|Contractor’s labor and other costs||$20,000|
|Travel & vehicle mileage||$100|
|Realtor commission and closing costs||$7,500|
|Total Expenses Not Including Purchase Price||$40,400|
|Total Expense Including Purchase Price||$90,400|
|Profit (Sales Price – Total Expenses)||$24,600|
Let’s say you live in Baltimore City and earn $60,000/year, putting you in the 22% federal income tax bracket. On the deal above, you can expect to pay:
Federal income taxes: $5,412 (22%)
FICA taxes: $3,764 (15.3%)
State & local taxes: $1,968 (8%)
Total taxes: $11,144 (45.3%)
Which puts your net income on the deal at $13,456 instead of $24,600.
Remember, as self-employed business, you’ll need to pay estimated quarterly taxes. If you fail to pay sufficient estimated quarterly taxes, the IRS will impose a penalty once you file your income taxes the following April.
How to save money on house flipping taxes
Don’t like the look of those tax figures above? Luckily, here are 5 options you can leverage to trim that tax bill back to more manageable levels:
1) Maximize deductions
While the other options below each have their pros and cons, consider this tactic mandatory.
Real estate investment tax benefits are many and varied. Almost all soft costs are deductible, including renovation expenses from labor to materials. While some of those soft costs are obvious and easy to deduct, such as the expenses that appear on your HUD-1 settlement statement, many new real estate investors don’t take advantage of the less obvious soft costs.
Do you have a home office? Deduct for it! Remember home flippers are classified as dealers, as businesses. You can deduct part of your rent or mortgage payment for your home office, part of your utility bills, plus any home office supplies and equipment.
You can also deduct for travel and vehicle expenses, as you drive to and from the property, to and from settlements, etc.
And of course you can deduct mortgage interest from your bridge loan with LendingHome or other hard money lenders.
The trick to maximizing your deductions is perfect record-keeping. Word to the wise: open a business bank account, so that you can keep all of your business expenses completely separate from personal expenses. When it comes time to file your taxes, you’ll know that every penny spent from that account can be deducted.
2) Do a 1031 exchange
IRS Section 1031 allows taxpayers to do a “like-kind exchange” to defer paying taxes. For real estate investors, that means being able to defer taxes by taking the profits from one flip and investing them in another.
In the example above, say you take the $24,300 profits and turn around and use them as a down payment on a larger $100,000 property. You file it as a 1031 exchange and pay no taxes on the proceeds…this year.
This is great for property investors looking to snowball their house flipping income to buy larger deals and earn larger profits. By deferring their tax bill, investors can take advantage of the magic of compounding returns, without those pesky taxes siphoning off half of the returns!
The catch? Eventually you have to pay the taxes when you stop churning your money through deal after deal, and you actually want to pocket some of those profits. And by that point, those larger profits may have put you in a higher tax bracket.
3) Hold the property for over a year
This option is hardly a plot twist, given the wide divide between normal income tax rates and capital gains tax rates.
Beyond the difference in tax rates, this income is classified as investment income rather than business dealer income, and therefore is not subject to FICA taxes. In the example above, a more patient investor would have paid a tax rate of 23% total (15% for capital gains, 8% on state and local taxes).
That comes to a tax bill of $5,658, nearly halving the original tax bill of $11,144.
Another option is to hold the property for a single tenancy, before selling it. You buy it, renovate it, lease it, and when the tenants move out, you sell it.
This strategy comes with several pros and cons. In addition to the dramatically lower taxes on the gains, investors can potentially enjoy monthly cash flow, even as the property continues to appreciate in value.
However, appreciation is far from guaranteed. What if the property goes down in value, rather than up? While less common, it happens.
Another risk is that the tenants damage the property that you just spent so much time and money renovating. Not every renter treats their home with respect.
Also consider the terms of your financing. If you borrow a bridge loan to buy and renovate a property, it’s a short-term loan not designed for long-term rentals. Besides having higher interest than a long-term mortgage, many bridge loans have term limits of under one year.
Finally, keep in mind that the longer you hold a property, the slower your “velocity of money” (how quickly you can turn over your investing capital to keep it working for you).
4) Do a live-in flip
What if you live in the property yourself for a year or more?
There are multiple advantages to doing a live-in flip. First, you can finance it with a homeowner mortgage, which are cheaper than hard money loans. While hard money loans are quick, flexible financing for short-term flips, they are not a viable long-term mortgage.
Second, you can do the repairs yourself at your leisure. Since you’re living in the property, you don’t have to carry the mortgage on a vacant property as a soft cost.
But perhaps best of all, you can avoid taxes altogether. As in, 0% tax rate.
If you live in a property for at least two out of the last five years, the IRS does not charge you any capital gains tax on profits up to $250,000 for individuals and $500,000 for married couples.
Of course, you won’t be flipping many houses if you wait at least two years between each one! But for anyone looking to do the occasional flip at their leisure, without scaling a house flipping business, it can be a great strategy.
5) Offset losses with profits
With the right research, preparation, and discipline, informed real estate investors can greatly reduce their risk of losses. They know the due diligence involved at every step of flipping a house. They know which home improvements add the most value, and how to price their properties post-renovation.
But in a worst-case scenario, a loss will offset the profits from your other flips, for tax purposes.
If you were thinking about trying to keep a property for over a year, or do a 1031 exchange, or jump through other hoops to avoid taxes, you may not have to do that this year if you suffered losses that offset your profits.
Filing and paying your taxes
As mentioned above, real estate investors have to prepay their taxes with quarterly estimated tax payments. To do that, investors must file a Schedule C form (also known as the 1040 Profit & Loss Form) with the IRS every quarter. Specifically, by January 15, April 15, June 15, and September 15.
Taxes may be inevitable, but that doesn’t mean the tax rate is fixed.
As a savvy real estate investor, you can minimize your tax burden through the 5 tactics above and include them as part of your house flipping business plan.
After all, the less you pay in taxes, the more money you’ll have to reinvest. And the more you reinvest your profits, the faster you’ll build wealth through flipping houses.
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 belong to the individuals referenced. NMLS ID: 1125207 Terms, Privacy & Disclosures. Copyright LendingHome Corporation 2019.