The housing market continues an upwards trajectory, offering a lucrative opportunity for any house flipper. Flipping a house in 2020 is a great way to generate self-employed income, but what about taxes? This article offers everything a house flipper needs to know about self-employment taxes.
Learn about how to make the most of deductible expenses and paper expenses for your 2020 taxes. Find out how you can reduce your tax liability on flipping a house. And, learn about how tax is calculated on active income, as well as short-term, and long-term capital gains.
The House Flipper Self Employment Tax Guide for 2020
If you are a house flipper or interested in investing in flipping a house, the first thing you need to understand is your income tax liability. Flipping real estate is considered as active income by the IRS. Therefore, any profit you make from flipping a property counts as a normal income.
Ordinary income carries a tax liability rate, between 10% and 37%. Capital gains carry a much lower tax rate than active income, with some capital gains being tax-exempt. For a house flipper, self-employment tax (SE tax) is lumped into your income tax liability.
Active real estate dealers pay taxes on the profit from flipping a property. Landlords, however, are subject to different tax rates. Property owners, who generate income through their property, are separated into two categories for the purpose of federal income taxes.
Flipping Houses as an Investor vs Real Estate Dealer
The IRS makes delineations between tax liability for real estate investors vs dealers. The nature of your income-generating activity determines whether the IRS considers you a dealer or an investor. At the end of the day, real estate investors carry a lower tax liability than dealers.
So, a house flipper has to know that which delineates a dealer from a trader. The IRS can consider you a dealer if you own multiple pieces of real estate simultaneously, frequently buy and sell properties, are a property broker, or most of your income comes from being a house flipper. The downside of becoming classified as a dealer-trader is that your income is taxed at the normal rate, and you pay an additional 15% self-employment tax.
Both dealers and investors, however, can take advantage of an IRS provision to reduce your tax liability. If you sell a property that was your primary residence, the sale is tax-free. To qualify as your primary residence, however, you must have lived in the residence for at least 2 out of the past 5 years.
It is possible for a house flipper to be taxed as a real estate investor. This means your income is subject to capital gains tax rules. And, capital gains are taxed at a much lower rate than that of earned income.
Generating Income from Short-term vs Long-term Capital Gains
There is a big difference in your tax liability when it comes to generating income from owning real estate. The biggest difference is in how your profit is derived after you flip a house. Do you sell the property as a real estate investor or as a dealer?
If you sell it as a dealer, the IRS taxes your income on the normal scale for active income. If you sell as a real estate investor, however, your taxes are determined by whether your gains are short-term or long-term.
Short-term capital gains are income generated through the real estate which you have owned for less than 12 months. So, if you flip a house and immediately sell it, the profit is counted as a short-term capital gain. If you wait to sell it until month-13, however, it counts as a long-term capital gain, and your tax liability is dramatically reduced.
If you generate short-term gains on flipping houses, you pay more in taxes than if your income is from long-term gains. Most average earners expect to pay around 15% for long-term capital gains, opposed to the nearly 30% tax liability for short-term capital gains. If you are classified as a dealer, you will pay more in taxes than if you’re a real estate investor.
Calculating Tax Liability for a House Flipper in 2020
Individual real estate investors have a significant tax advantage and thus better cash flow than real estate dealers. An investor typically pays a 15% tax on their income where a dealer pays a normal tax rate of up to 37%. They also pay an additional tax for self-employment income up to 15.3%.
That can add up fast! Here is an example of two properties sold – one by an investor and one by a dealer:
Jill buys a property for $300,000 and she invests an additional $70,000 in improvement to the property. After 13 months of owning the property, she sells it for $470,000. Jill made a clean $100,000 from owning this property for just over a year.
If Jill was considered a real estate investor, her $100,000 gain would be considered a long-term capital gain. Jill files as a single on her tax return, so she has an automatic standard deduction of $12,200. She will also receive $39,375 in free long-term gains.
She doesn’t pay a dime on those free long-term gains. The rest of her income is taxed at 15%. Jill will end up paying $7,264 in taxes on the $100,000 gain.
If instead, Jill was considered a real estate dealer, she would pay more in taxes. Now she would pay ordinary income tax rates that max out at 37%, as well as self-employment tax that maxes out at 15.3%.In this situation, Jill will still receive the standard deduction of $12,200 but everything after that is taxed.
Jill would end up paying $24,195 in taxes on the same $100,000 gain! That is $16,932 in cold hard cash that the IRS will gladly take.
Get Tax Help for House Flippers
The rate at which you flip and sell houses determines whether your income is subject to self-employment taxes, or capital gains taxes. But, if you’re an investor, you can roll proceeds directly into your next investment to avoid paying tax on it, altogether. You cannot take advantage of rolling proceeds if, however, you are holding property with the express intention to resell.
If you are a house flipper, contact a tax professional to find out how to reduce your income tax and self-employment tax liability. And, help others save money on their taxes, by sharing this article with your social media community.