Learn about how you can reap the rewards of investing in the most tax-advantaged asset class in America.
With the rise of reality TV shows like Flip or Flop and the increased interest in HGTV, public interest in property flipping is at an all-time high. Last year, this interest manifested itself into reality. Based on statistics from ATOM Data Solutions, the rate at which homes are being flipped has reached a 14-year high.
Investors are also receiving an increased rate of return from their fixer uppers. So it's no wonder the market is booming. While this investment strategy can be lucrative, it does not come without some significant tax implications (i.e., the house flip tax). You should review these with your tax advisor before the May 17 filing deadline.
Tax treatment of fix-and-flips
The tax treatment of your fix-and-flip investment hinges upon whether or not you're considered to be an investor or a dealer for tax purposes. While there is no hard and fast rule to distinguish between a dealer and an investor, in a series of cases, the tax court has consistently looked at certain factors to determine who is an investor and who is a dealer.
You should note that this is a heavily litigated issue, so working with an advisor before acquiring a property is advisable. An advisor can work through the case law with you to determine whether or not you're a real estate investor or a real estate dealer.
Real estate dealer
In general, to arrive at the conclusion that an individual is a real estate dealer, the court has consistently looked at the following factors:
- The property owner’s intent: whether the property has been acquired during the ordinary course of business.
- The frequency and sustainability of the sales.
- The degree of solicitation, advertising, and sales activity.
- Sustainability of transitions.
- Duration of ownership: nature and purpose of property ownership.
While the above list is not exhaustive, the court generally looks at the above factors. The court may also look at other factors, such as whether the owner has control over the property and the location of the business office.
If the court determines that you are a dealer, you will be exposed to less-than-favorable tax treatment. At the federal level, dealers are taxed at the ordinary income tax rates. In addition to being taxed at the ordinary income tax rates, real estate dealers are exposed to self-employment taxes. The self-employment tax applies to your net earnings. At present, the self-employment tax rate is 15.3%. At the state level, dealers will also be exposed to state income tax.
Real estate dealers are also barred from completing a section 1031 exchange (the property must be held for investment purpose) and they are also prohibited from completing a section 453 installment sale. Dealers also can not claim the depreciation deduction and may also be required to capitalize their expenses instead of deducting them in the current tax year.
As you can see, being classified as a real estate dealer is the least-beneficial tax status. For this reason, working with an advisor before acquiring the property is essential.
Real estate investors
Unlike real estate dealers, real estate investors are able to enjoy the more-favorable capital gains tax treatment. Capital gains are classified as either short-term capital gain or long-term capital gain.
Short-term capital gains taxation
Assets are classified as short-term assets and thus taxed at the short-term capital gain rate when an investor holds the asset for less than a year. Upon disposition, the gains from the assets are taxed at the ordinary income tax rates. This is not the most favorable tax treatment because the ordinary income tax rates can go up to 37 %. That is a significant amount of taxes to pay when your main goal as a flipper is to maximize your gain. The ordinary income tax rates for the current tax year 2021 are as follows:
|Tax Rate||Taxable Income (Single)||Taxable Income (MFJ)||Taxable Income (MFS)||Taxable Income (HOH)|
|10%||$0 to $9,950||$0 to $19,900||$ 0 to $9,950||$0 to $14,200|
|12%||$9,951 to $40,525||$19,901 to $81, 050||$9,951 to $40,525||$14,201 to $54, 200|
|22%||$40, 526 to $86,375||$81, 051 to $172, 750||$40, 526 to $86,375||$54, 201 to $86, 350|
|24%||$86,376 to $164,925||$172,751 to $329,850||$86,376 to $164,925||$86,351 to $164,900|
|32%||$164,926 to $209,425||$329,851 to $418,850||$164,926 to $209,425||$164,901 to $209,400|
|35%||$209,426 to $523,600||$418,851 to $628,300||$209,426 to $314, 150||$209,401 to $523,600|
|37%||$523,601 or more||$628,301 or more||$314, 151 or more||$523,601 or more|
Long-term capital gains taxation
On the other hand, long-term capital gains tax rates are more attractive. In order for investment property to become subject to the long-term capital gains tax treatment, the property must be held for a year or more. The following are the long-term capital gains tax rates for 2021.
|Federal Capital Gain Tax Rate||Taxable Income (Single)||Taxable Income (MFJ)||Taxable Income (MFS)||Taxable Income (HOH)|
|0%||0 to $40,000||$0 to $80,000||0 to $40,000||$0 to $54,100|
|15%`||$40,001 to $445,850||$80,001 to $501,600||$40,001 to $250,800||$54,101 to $473,750|
|20%||$445,851 or more||$501,601 or more||$250,801 or more||$469,051 or more|
As you can see, if you hold your capital asset as a long-term investment, the amount of taxes that you owe will hinge upon your income category and your filing status. Additionally, you may also be exposed to state capital gains tax and net investment income tax. Since you will be exposed to various taxes , in order to maximize your profits, it will be in your best interest to keep track of your deductible expenses so you can offset your gains.
Does the section 121 exclusion apply?
In general, the section 121 exclusion from capital tax will only apply where the property is the primary residence of the investor and all other conditions are met. If you meet the specified conditions, you may be eligible to exclude $250,000 from capital gains.
In addition to the potential eligibility for the exclusion, you may be able to deduct the expenses you incurred.
In general, most costs associated with flipping the property (capital improvements) will be added to the basis and will not be immediately deductible until the property is sold. While this is true, some of the cost may be expensed during the current tax year if the property operates like a business (i.e., you're a real estate dealer).
Millionacres bottom line
Adding house flipping to your portfolio can be a great strategy to maximize your profits over a short period of time. While this strategy is great, the tax implications can outweigh the reward of turning over quick profits. Remember, it's not about how much you earn, it's about how much you keep. For this reason, working with your tax advisor at the initial planning stage is key. This is your best bet to not only maximize your deductions during the tax season, but also retain your capital gains.
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