Over the past several years, I have acquired a number of clients who buy homes, fix them up, and sell them for a profit. Needless to say, this is an extremely risky activity, but several of my clients have been generating very good ROI’s and I expect that this will continue to be a growth area for the foreseeable future.
There are also a number of tax traps that are specific to house flipping, and so I thought I’d put some information up here. Note that these are general observations of mine, and if you are in the business of flipping homes you really need to be working with a CPA who has some expertise in this particular area and should not try to do your taxes yourself.
The Key Question: Are you in the business of flipping homes, or are you doing this strictly as an investment?
This is a very important question because it will dramatically affect how gains are taxed, to what extent any losses you have will be deductible, and how you should structure your activities.
If you are an investor, any gains would be taxed as capital gains, which is good. Since this is an investment activity, you would also not have to pay self-employment taxes on any profits, which is very good. But you would also potentially be subject to the 3.8% Net Investment Income Tax, which is not so good. And if you were to incur a loss, it would be subject to capital loss limitations, meaning that you can only deduct $3,000 per year (or use these losses to offset other capital gains.)
If you are in the business of flipping homes, any gains would be taxed as ordinary income and subject to self-employment tax. This is a very bad outcome, as self-employment taxes would be 15.3% of your net profit from the activity. However, any losses would be treated as an ordinary loss not subject to capital loss limitations.
Overall, it is generally better if your house flipping is treated as an investment activity instead of a business. However, whether your home flipping is an investment or a business is based on the particular facts and circumstances of your situation. Just because you take a particular position on your tax return does not necessarily mean the IRS would respect that position if you were to be audited. Therefore, you should work closely with an experienced CPA to manage your risk. If there is even an outside chance that the IRS could classify you as a business, then you should strongly consider forming an S-Corporation in order to manage your self-employment tax liability.
Other Important Points:
- You will not be able to exclude a flipped home under the Section 121 Primary Residence Exclusion. In order to qualify for that, the Home must have been your Primary Residence for 2 out of the last 5 years. However, if you were to buy a Home, fix it up, and actually live in it for 2 years, theoretically you could then sell it and exclude any gain from tax under IRC 121. However, in order to satisfy this requirement, you would need to do this as an individual investor and it would probably have to be a one-off, or the IRS could challenge the sale and say that you are in fact a dealer.
- Likewise, you will generally not be able to defer gain via a 1031 Exchange. While a full description of IRC 1031 is beyond the scope of this article, the cliff notes are that a properly structured and executed 1031 Exchange allows you to defer gain on the sale of real property held for trade or investment provided that you identify replacement property within 45 days and close on the purchase of your replacement property within 180 days. However, the IRS classifies people who actively buy, renovate, and re-sell property on a continuing basis as dealers, not as investors. This is unfortunate, because the IRC specifically states that inventory does not qualify for Section 1031 treatment.
- If you are thinking about using funds from a Self Directed IRA, be very careful. While using funds from a Self Directed IRA could potentially be a very smart tax saving move, you must be extremely careful to not violate the self-dealing rules. In a worst case scenario, your entire IRA could become taxable and you could be subject to a 10% early withdrawal penalty, which would be a disaster. Therefore, you should consult with a CPA before using funds from a Self Directed IRA.
- Costs associated with your home flipping activities will generally need to be capitalized and added to your basis. You will have a taxable event in the year that your home is sold, which may not necessarily be the same year as when it was purchased.
- If you are going to conduct your activities through an entity, an S-Corporation will almost always be your vehicle of choice. An S-Corporation’s ordinary business income is not subject to self-employment tax, whereas your income from an LLC would be (unless the LLC elected to be taxed as an S-Corporation.) However, if you form an S-Corporation you are still required to pay yourself a reasonable salary. You should consult with a CPA on this.
- If you are a California resident but are flipping homes outside of California, you will most likely still need to pay California taxes on any gains or losses. However, you will be able to claim taxes paid to any other States as a credit to help offset your California tax liability.