House Flipping and Tax

However, many investors also were in for a shock when they began telling the Internal Revenue Service about their house-flipping profits. Much of the confusion comes from a misconception that stems from the laws regarding the sale of a personal residence. In 1997, a law went into effect that allows many homeowners a tax-free sale of their home. Although it was a boon to homeowners hoping to move up to a new property, that law has no effect whatsoever when it comes to the sale of a piece of investment property.

Regardless of how it was made, the IRS treats investment profit as capital gains and taxes it at two levels, depending on how long you owned the investment. If you owned it for less than a year, it's considered a short-term capital gain and is taxed at ordinary income tax rates, which could be as high as 35%. However, holding an investment for more than a year allows you to reduce your maximum tax to 15%, which can amount to a considerable increase on your bottom line.

Most flippers hope to turn the property around as quickly as possible, even though the tax burden will be greater. Then they move on to the next house. The difficulty with that strategy is that the IRS may look at your home flipping enterprise as a business instead of an investment, which means paying the higher of the two tax rates on every transaction. There's no precise rule of thumb. The IRS tries to determine if it's a business or investment strategy on a case-by-case basis.

Don't overlook that scenario. The IRS is making an extra effort to generate more income for the government, so they're taking an even closer look at flippers to see if they're in it fulltime or just as a casual investor. Although there are no hard-and-fast guidelines, if you're turning over more than two or three properties a year, you may be flirting with having your real estate activities labeled a business.

If the IRS decides your flips are a business, the investment changes from a capital asset to a means of producing income that's subject to ordinary tax rates, plus the extra responsibility of another 15.3% in self-employment taxes.

That doesn't mean there isn't good money to be made in house flipping. It also doesn't mean you should either not begin flipping houses or stop flipping them if you've been doing it for awhile. What it really means is that you should begin taking a worst-case scenario into account whenever you enter into negotiations for a new home to flip. If you'll have a 35%-50.3% tax bite coming out of the transaction, that simply means that you'll have to get a better deal on each house if you're going to continue making the amount of money you've been used to making.

See also IRS Code Section 1031 to Defer Capital Gains

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