Although house flipping isn’t as attractive in the 2020s as it was in the 1990s and early 2000s, it is still a viable way to make a living in real estate. With sufficient cash flow, a little bit of know-how, and a good market to work with, a person can make a tidy little profit flipping houses. But house flipping does have its downsides. One of them is taxes.
The tax issue for house flippers boils down to definition. According to Salt Lake City’s Actium Partners, a real estate bridge loan lender active primarily in Utah, house flippers are considered investors for lending purposes. Even though Actium doesn’t deal in house flipping loans themselves, they and their industry peers still consider house flippers investors.
Unfortunately, the IRS doesn’t necessarily agree. Despite not having a concrete definition for the property dealer, the IRS considers most house flippers dealers rather than investors. You could make the case that this preference is solely based on the short-term nature of holding real estate assets. House flippers tend to want to get acquired properties back on the market as quickly as possible.
Sale Profits and Capital Gains
As a homeowner, you could choose to sell your home and move on. Any profits realized by that sale would be treated as capital gains by the IRS and state taxing authorities. Capital gains taxes would apply. That’s the bad news. The good news is that capital gains taxes are substantially lower than income taxes. As an added bonus, selling your home will not push you into a higher income tax bracket or cost you nearly as much in real terms.
What many people do not understand is that investors who do not draw a regular income pay capital gains on their profits rather than income tax. That’s why wealthy individuals who earn the bulk of their livings from investment returns don’t pay income tax. They pay capital gains tax instead.
This is where things get tricky for house flippers. Even though a hard money lender would consider a house flipper an investor, the IRS does not. Rather, they see the house flipper as a dealer who generates a regular income through the business of buying and selling houses. The houses are essentially products.
Profits Are Subject to Income Tax
Because the IRS does not view house flippers as investors, all their revenues are considered business revenues. That means house flippers are subject to the same income and business taxes. They can also write off a certain percentage of their expenses. But again, there is a trade-off.
Unless the house flipper sets up a limited liability corporation (LLC) or some other type of legal business entity, he is considered a sole proprietor. As such, he pays self-employment tax above and beyond income tax. Self-employment tax is the combined FICA contributions of both employer and employee. Needless to say, it can be a very hefty tax bill.
The advantage of setting up an LLC is that the house flipper can draw a salary as a paid employee, thus keeping business and personal income separate. It’s a bit trickier to do things this way, but it is possible with the right business structure and an experienced accountant handling the books.
House flippers generate revenue by buying houses, fixing them up, and reselling them. Lenders and other business professionals consider house flippers investors. But as far as the IRS is concerned, house flippers are dealers. They are dealers because they are buying and selling a product rather than investing in an asset capable of generating returns over a considerable amount of time.