6 Tax Saving Tips For House Flippers
Chris Barrett
Introduction
In the realm of house flipping, every dollar counts when it comes to profitability. However, a prevailing myth has led many to believe that there are limited options for tax savings, particularly since house flippers are classified as dealers by the IRS. Consequently, each house flip is often carried out with minimal tax efficiency, leaving potential savings on the table.
In this article, we will debunk this myth and shed light on smart tax moves specifically tailored to house flippers. By implementing these tax strategies, you can unlock valuable savings that contribute to the overall success and profitability of your house flipping business.
The Types of Taxes Affecting House Flippers
To navigate the tax landscape as a house flipper, it’s crucial to understand the various types of taxes you’ll encounter. Generally, house flippers encounter three primary types of taxes:
- Short-Term Capital Gains: When you sell a property within a year of acquiring it, the profit from the sale is classified as short-term capital gains. These gains are subject to taxation at your ordinary income tax rate.
- Long-Term Capital Gains: If you hold a property for more than a year before selling, the profits will be considered long-term capital gains. Long-term capital gains are generally taxed at lower rates than short-term gains, providing potential tax advantages.
- Self-Employment Taxes: House flippers are self-employed individuals and therefore are responsible for paying self-employment taxes. These taxes encompass both the employer and employee portions of Social Security and Medicare taxes.
Understanding these tax categories is essential because each strategy we discuss in this article aims to either reduce or potentially eliminate the impact of these taxes.
1. Making S-Corporation Election
When flipping houses as a sole proprietor or an LLC, the entire income you generate is typically subject to self-employment taxes. However, you can optimize your tax structure by making an S-Corporation (S-Corp) election. Here’s how it works:
By filing Form 2553 for your LLC you can elect to be taxed as an S-Corp. This election allows you to pay yourself a reasonable salary, which is subject to self-employment taxes, while the remaining profits from your business are not.
By taking advantage of this strategy, you can significantly increase your tax efficiency. With self-employment taxes amounting to 15.3%, making an S-Corp election can result in substantial tax savings.
2. Flipping Your Own Home and Utilizing Section 121 Exclusion
If you’re open to living in the home you’re flipping, this strategy has the potential to completely eliminate the amount of tax you owe.
The Section 121 exclusion allows individuals to exclude up to $250,000 in gains from taxation, while married couples can exclude up to $500,000. To qualify for this exclusion, you must meet the following criteria:
- Residency Requirement: You need to have lived in the home for at least 2 out of the last 5 years.
- Timing Limitations: Note that you cannot utilize this exclusion more than once within a 2-year timeframe.
By leveraging the Section 121 exclusion, you can potentially eliminate the tax burden associated with the gains from flipping your own home, allowing you to keep more of your profits.
3. Holding Property for a Year: Maximizing Long-Term Capital Gains
When you purchase a property and flip it within one year, the gain on that sale is classified as a short-term capital gain. Short-term capital gains are subject to taxation at your ordinary income tax rate, which can be as high as 37% in 2023. Additionally, these gains are also subject to self-employment taxes at a rate of 15.3%.
However, by holding the property for at least one year, you can take advantage of long-term capital gains treatment. Here’s how it benefits you:
- Preferred Tax Rate: The gain on the sale will be considered a long-term capital gain and taxed at the preferred capital gains rate, which currently maxes out at 20% in 2023. This is significantly lower than ordinary income tax rates.
- Exemption from Self-Employment Taxes: Long-term capital gains are not subject to self-employment taxes.
By strategically holding properties for a year or longer before selling, you can optimize your tax position, benefiting from long-term capital gains tax rates and eliminating the self-employment tax burden.
4. Renting Property Before Selling: Leveraging a 1031 Exchange
Renting out a property before selling it can open up opportunities for tax deferral through a 1031 exchange. Here’s how it works:
A 1031 exchange allows taxpayers to defer taxes on the gains from the sale of real estate held for investment purposes. However, it’s important to note that the IRS excludes properties held for sale by dealers, and house flippers typically fall into this category. Consequently, they cannot take advantage of a 1031 exchange for their flipping activities.
Nevertheless, many house flippers have a long-term investment strategy alongside their flipping ventures. They may come across properties that aren’t suitable for flipping at the moment but could serve as profitable long-term investments.
In such cases, you can purchase the property, perform the necessary rehab, and then rent it out to tenants for a few years. By doing so, you create an opportunity to qualify for a 1031 exchange and defer taxes on your gain when you eventually sell the property.
To further enhance this strategy, consider exploring the possibility of refinancing the rehabbed property to withdraw your initial investment tax-free. You can then reinvest this money into additional flips, maximizing your returns and expanding your house flipping portfolio.
By strategically renting properties before selling them and utilizing the benefits of a 1031 exchange, you can optimize your tax position, defer taxes, and potentially leverage your initial investment for further house flipping opportunities.
5. Quality Bookkeeping to Optimize Tax Deductions
There are two main benefits of keeping quality records:
Compliance and Deduction Optimization: Keeping accurate records is essential for ensuring compliance with IRS regulations. Additionally, it allows you to identify and claim every possible deduction available to you as a house flipper.
Project Performance and Budget Management: Effective bookkeeping provides you with valuable insights into the financial performance of your house flipping projects. This level of financial visibility empowers you to make informed decisions and increase overall project profitability.
6. Qualify for real estate professional status (REPS)
If you’re a full-time house flipper, you may have the opportunity to qualify for Real Estate Professional Status (REPS). REPS is a tax designation that offers significant advantages for individuals who actively manage their rental real estate properties.
Here’s how REPS can benefit you:
By attaining REPS, you can treat your rental activities as non-passive activities for tax purposes. This classification allows you to generate paper losses through depreciation, which can be used to offset income from other non-passive activities.
As a house flipper, you can strategically time the gains from your flips with the accelerated depreciation on your long-term rental properties. This combination allows you to lower your taxable income and therefore increase your tax efficiency.
Work With a Real Estate CPA Firm
It’s important to note that each of these strategies contain nuances that can be very difficult to navigate alone. Working with a CPA firm specialized in real estate, such as Midwest CPA, can help you navigate the requirements and optimize the tax efficiency of your house flipping business.
While we’ve got you here, why not take a look at our real estate CPA services.
Disclaimer
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.