When it comes to flippers, there’s always one question: how do I minimize my taxes? The IRS classifies Real Estate professionals as either Investors or Dealers. The IRS views both differently. Dealers are normally taxed at their ordinary income tax rates (which caps out at 39%). Investors are usually taxed at Capital Gain rates (which caps out at 20%). One of the major factors is how long a property or asset was held. If a property is sold and only held at 11 months, it is taxed per the ordinary income tax rules. If it is held over a year, it is taxed per the capital gains rates. This is a large difference and most Dealers would have been taxed more than the Investor in this scenario. When figuring the net profit from a deal, taxes should always be factored in. Taxes are a major part to coming up with the correct profit margin and investing in your next deal. Below are some tips for a flipper:
- Should I hold the property? – This scenario is a double-edged sword. If the house is fully appreciated should you sell it? As we know home values aren’t guaranteed. You are also taking a risk of becoming property rich. You must weigh your options to see if taking the risk is worth it to save money on your taxes. In some situations, if your evaluation comes back with the property able to sell at a high then it is best to do that deal and factor the income taxes in. If you are holding a property for 10-11 months and you finally get an offer, it might be best to wait to reap the tax benefits. It is best to weigh the pros and cons of the deal before pulling the trigger.
- There’s an IRS exclusion if you lived in the property – The IRS will exclude up to $250,000 if you are single and $500,000 if you are married from Capital Gains. What’s the catch? You would need to live in the property 2 of the last 5 years. This is a strategy that is effective for the casual flipper or someone who is looking to sell a property that was once their primary residence.
- Improvements and Repairs – With any flip there are expenses. Please keep track of these as expenses directly related to the property will be a deduction. These expenses include travel, repairs, labor costs, contractors, maintenance etc. Tracking these expenses proves to be what truly makes the deal work from a tax perspective. It’s not about the money you make, it’s about what you keep.
- Should you do a 1031 exchange? – a 1031 exchange is not a cure all for investors. Please keep in mind that it is a Tax Deferred exchange not a tax avoiding exchange. A 1031 exchange should always factor in the goals or an investor long term. If your goal is to accrue assets and retire then this might be a great route. If your goal is to have liquidity, then this might not be the best route. 1031s are fast acting, which means you need to plan ahead and properly. Please make sure to review the parameters of a 1031 before the initial property is even sold.