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Who doesn’t like to save money on taxes? A real estate investor too would want to understand which expenses can be deducted when filing for taxes on flipping houses. Obviously, the tax deductions will have a direct impact on the total taxable income. A clear idea will therefore allow them to plan and budget for any future real estate projects.
What’s the 70% rule in house flipping?
If you want to determine the maximum price you should consider paying for an investment property, use the 70% rule of real estate investing. That’s to say, you should not pay more than 70% of the after repair value aka ARV, minus all the repair and home improvement costs.
The 70% rule in house flipping is a good way to help you assess your profits when you fix-and-flip a property.
Needless to say, the house flipping business is a costly one, with some major expenses. Unfortunately, most of the expenses are not immediately tax-deductible. Instead, they are added to the original value of the property.
Some of the capitalized costs comprise:
- The cost of the property
- Material costs
- Labor costs (direct and indirect)
- Cost of utilities
- Equipment depreciation
- Real estate taxes
- Production period interest
Ordinarily, if you buy real estate, fix it up, and sell it later, the profit is taxed under the capital gains rules. Moreover, you can qualify for more favorable special rules if the property in question is your principal residence. Interestingly, if you live in the primary residence for more than two years (during the five-year period before the house sale), you may be able to exclude the gain from the sale from being taxed altogether.
How are house flipping taxes typically calculated?
There are two types of capital gains from house flipping. Any income from flipping a house that you’ve owned for less than 365 days is classified as short-term capital gains. The taxation is calculated as an ordinary income tax rate, depending on your tax bracket. It’s best to consult a tax professional to determine your taxation category and total taxation amount.
On the other hand, if you’ve been living in the property for more than two years, the profit from the house sale will be considered for long-term capital gains taxes.
While most middle-class taxpayers who flip their house can expect to pay a 15% tax rate on long-term capital gains, a seasoned house flipper or a dealer will pay much more.
If you’re someone who actively purchases and remodels real estate for profits, the IRS classifies you as a dealer, not a real estate investor. Your real estate is treated as inventory instead of capital assets. Any profit you make on the sale of such properties will be treated as your income and will be subject to self-employment taxes.
The logic is simple — If you run a house flipping business, with a real estate investing business plan, you’ll be more likely to be profitable and must pay more in taxes.
How much profit can you get from flipping a house?
If one does it smartly, house flipping can be a really profitable business. In 2019, flipped homes sold for an average price of approximately $218,000. That meant a gross profit of almost $63,000. Do note that this gross profit did not include the total amount spent on repairs and home renovations.
Want to create a budget for your home renovation project? Try our free remodel cost estimator; it’s easy and convenient to use!
How to save taxes on flipping houses
While flipping houses can help you make big profits, there’s a sizable tax bill to consider. Fortunately, there are some measures you can take to save money on house-flipping taxes. Your money-saving options are:
Maximize your deductions
There are varied real estate investment tax benefits, including deductions on renovation expenses. You just have to do some research and take advantage of the soft costs.
You can deduct for a home office, part of your rent, part of your utility bills, travel, and vehicle, and mortgage interest rates from a bridge loan or a hard money lender.
Keep in mind that you’ll have to maintain organized record-keeping. In addition, you must open a business bank account and keep your business expenses separate from your personal expenses. This tip will come in handy when it’s time to file your taxes and tax returns.
Do a 1031 exchange
The IRS Section 1031 allows taxpayers to defer paying taxes by taking the profits from one flip and investing them in another.
For example, if you use your profits as a down payment on a larger property the same year, you can file it as a 1031 kind exchange and pay no taxes on the proceeds.
This is a huge advantage for property investors who’re looking to snowball their house flipping income to get larger deals and profits.
Lease out the property for over a year
Beyond the difference between normal income tax rates and capital gains tax rates, if you hold the rental property (preferably for a single tenancy), before selling it, your income classifies as investment income instead of a business dealer income. Therefore, it’s not subject to FICA taxes and has lower taxes on the gains. The trick is to buy a fixer-upper, renovate it, lease it, and sell it after the tenants move out.
Live in the property
A live-in flip comes with many advantages. You can finance the house with a homeowner mortgage (cheaper than hard money loans) and do the repairs yourself — at your leisure. In case you live in the house for at least two out of the last five years, the IRS doesn’t charge any capital gains tax on your profits if they are up to $250,000 (for singles) and $500,000 (for married couples).
Reduce any risk of loss
You can reduce your risk of losses if you do the right research and preparation. Know which home improvements will add the most value, how to prepare the house for sale, and how to price the property right post the home renovation.
Want to know which home improvements will give you maximum return on investment? Kukun’s How to Prepare Your House for Sale tool will give you the best answer.
File and pay your taxes on time
Real estate investors must prepay their taxes quarterly with estimated tax payments. They need to file a Schedule C form or the 1040 Profit & Loss Form with the IRS. The quarters are around January 15, April 15, June 15, and September 15 every year. Keep this in mind to keep a clean tax profile and save yourself from paying tax penalties.
Read more: Do I pay tax when I sell my second home?
We understand that taxes on flipping houses are inevitable, but that doesn’t mean you can not minimize your tax burden. We hope this article helps you do just that. After all, the lesser taxes you pay, the more money you’ll have to reinvest. The more money you invest, the more are your chances to make a huge profit through flipping houses.