Last Updated on July 27, 2021 by Mark Ferguson
Flipping houses can be a very lucrative business, but in most cases, you have to pay a lot of taxes. There are ways to pay fewer taxes flipping, but it takes some sacrifices from the investor and a lot of time. Most flips are taxed at the ordinary income tax rate, but in some cases, you may be able to pay only the long-term capital gain tax rate. I flip many houses a year and to me, it is not worth the time it would take to pay fewer taxes on flips, but for others, it may be worthwhile. I am not an accountant and for specific legal or tax questions please consult an attorney.
What are the tax rates on fix and flips?
Flipping houses is considered a business by the IRS, not an investment. Rental properties are considered an investment and have much more favorable treatment from the IRS. Rental income itself is considered ordinary income, but you can depreciate rentals, which is a huge tax advantage.
When you sell rental properties, the profit is often considered long-term capital gain and taxed at a much lower rate than ordinary income. If you make $30,000 on a rental property sale you may only pay 15 percent taxes instead of twice that if you are in one of the higher tax brackets. It is possible to flip a house and pay that lower tax rate, but there are many things you have to do to qualify your property.
Can a flip be considered a rental property?
The IRS tax codes are not the clearest things in the world. They tend to be very vague when giving instructions on how to figure taxes. The IRS says a rental property has to be held for a certain amount of time for it to qualify for long-term capital gains. However, they do not specify what that time frame is. Many people assume it is one year, but there are no guarantees with the IRS. Some even argue a property has to be rented, not just held for one year to qualify.
It is argued that you can buy a house you intend to flip, fix it up, rent it for one year, and then only pay long-term capital gains taxes. However, the IRS has many intricacies and you should always consult an accountant when trying to figure out the tax code. The IRS created this code because they felt dealers or professional house flippers should have to pay ordinary income tax on their earnings because it is their profession. Just like a doctor, real estate agent or most anyone has to pay ordinary taxes on their wages. If you are flipping ten houses a year, holding them all for over a year, and then trying to pay only long-term capital gains on the taxes, the IRS may say you are a dealer and you owe ordinary income taxes
Is it worth it to pay fewer taxes on flips?
For me, it is not worth holding properties for over a year to save money on taxes. If I have to rent them for a year it would really not be worth it. I try to sell my flips in six months or less, although that does not always happen. Here are the concerns I would have holding on to a flip longer than I have to.
- I have a limited amount of money I can spend on flips. It takes almost $50,000 of my own cash to flip a house and I have from four to ten going at one time. If I had to hold them for one year I would not be able to flip as many houses, because I would not have the cash to keep buying them.
- I have to pay interest and carrying costs when I hold flips. Every month I hold a flip I would have costs piling up that would eat into my profits. My carrying costs can be as much as $1,000 a month and I have cheap financing.
- My loans are only one year long on my flips. If I held them longer I would have to pay off those loans or refinance them, which would greatly increase my costs.
- The longer you hold a property the more risks there are the market could change. I buy rentals for cash flow and I am not as concerned about market changes, because I will make money with rent. You make money on flips from buying low and selling high. If you hold a property for over a year, the market could decrease and you could lose money.
All of these factors are assuming I hold a flip for one year, but what if I rented the flip to make up for the costs?
Does it make sense to rent a flip for one year to pay long-term capital gains taxes?
If I were to rent my flips after I fixed them up, I might be able to get away paying long-term capital gains tax. Again, there are no guarantees because I am a professional flipper. Here are the problems I see with renting a flip.
- I make a lot of repairs on my flips and I want them to look great when they are listed. If I rented the property I risk the tenants messing up all the new fixtures, paint, flooring, and more. I can’t wait to make repairs, because most of my flips need a lot of work and cannot be rented in the state I buy them in.
- I would have to refinance the property or pay off my loans if I rented the houses as well.
- After I repair the house I would have to take time finding tenants, checking references, advertising, and signing leases. Most tenants want a long-term lease, which means I would have to rent the house for a year. It takes time to repair the property and I would want to sell the property after the tenants moved out. I would have to hold the properties well over one year, probably close to 18 months to make renting work.
How much money would I save by holding these properties?
If I go to all this trouble and time to pay fewer taxes, what would I actually save? Assuming the long-term rate stays at 15 percent, I would save about 20 percent on taxes. However, there is a push to increase the long-term capital gain tax rate. I average about $30,000 in profit on each flip, which would equate to $6,000 in tax savings on each flip. That is a lot of money to save, but I am actually getting more money overall?
If I held my properties longer I would have to flip half the houses I do now. If I flip ten houses a year I would make $300,000. If I could only flip 5 houses a year, I would make $150,000 a year, but pay fewer taxes. If I made $300,000 paying 35 percent in taxes I would pay $105,000 to the IRS. If I made $150,000 paying 15 percent in taxes I would pay $22,500 to the IRS. I pay a lot less in taxes, but I don’t care how much I am paying, I care how much I am keeping. In one scenario I keep $195,000 and in the other scenario, I keep $127,500.
Not only would I make much less money holding the properties, but I would also risk the IRS saying sorry you don’t qualify since you are a dealer and I would have to pay the full taxes. I also risk the market changing and I didn’t even consider the refinancing costs or carrying costs, although rent may make up for some of that.
Can corporations lower the tax rate on flips?
New tax laws are constantly being enacted and using a corporation to flip houses may save you money. My accountant suggested I use an S corp and that is what I do. With the deductions corporations get I save money but those tax laws could always change.
Can you use a 1031 exchange on flips?
Some people say you can use a 1031 exchange to flip houses but that is a tricky situation. A 1031 exchange is meant for rental properties and investments, not fips. You most likely have to hold the property a year and rent it out but again please talk to a professional!
I make more money by paying more taxes on my flips because I can flip more houses. There is also less risk with the market and tenants. For some people who only flip one house a year, maybe it makes sense to turn it into a rental before you sell. Always talk to an accountant to make sure you are following the rules in these matters.