Ed note: Owning real estate can make your tax return a bit more complicated. Figuring taxes when you flip real estate as a side business can be mind-boggling. The most important thing to know is that it is treated very differently from regular home ownership. Here are a few more things to keep in mind.
There is a lot of confusion when it comes to taxes and flipping houses for profit. For most people, real estate is considered a capital asset. In those cases, a sale can qualify for preferential capital gain tax rates. However, when you’re in the business of flipping houses for profit this may not be the case.
Normally, if you purchase a piece of real estate to fix up and sell it at later date, the profit is taxed under capital gains rules. Furthermore, if the property qualifies as your principal residence while you own it, and you live in it long enough (more than two years during the five-year period preceding the sale), you can often exclude the gain from taxation altogether under special rules for homeowners.
But the rules are different for individuals who actively purchase and remodel real estate for profit on a continuing basis. They are classified by the IRS as dealers rather than investors. For these people, the real estate is treated as inventory, rather than capital assets, and the profits on the sale of those properties are treated as ordinary income, subject to the self-employment tax.
Another source of confusion is that many potential flippers believe they can avoid taxation if they roll the proceeds of the sale into purchasing another project to flip (i.e., the property ladder theory). But if you’re considered to be in the trade or business of flipping real estate, this treatment isn’t allowed for property held for resale.
House flipping can be costly, with numerous expenses incurred along the way. Most of these expenses are not immediately deductible. Instead, they must be capitalized into (i.e. added to) the basis (the original value) of the residence. You get a tax benefit from these expenses when you sell the property as the taxable gain is reduced by the amount of basis in property.
Capitalized costs include:
- The cost of the home itself
- Direct materials
- Direct labor
- Indirect labor
- Equipment depreciation
- Production period interest
- Real estate taxes allocable to each project
Lastly, anyone watching reality TV knows there are dozens of pseudo-celebrity house flippers who offer their own courses and seminars purporting to teach individuals how to make it big in the business. For most individuals, expenses incurred in attending these courses are nondeductible under both the education expense and investment expense rules. Also, these courses will not qualify for any of the education tax credits.