TAXATION OF HOUSE FLIPPING
House flipping has become a popular and profitable endeavor as housing prices continue to rise and the supply of homes is in short supply. The taxation of the profits of house flipping presents several issues that I will briefly explain. As always, your situation may vary and you should consult your tax advisor for advice that is particular to your situation.
The profit or gain from flipping a home is determined by subtracting the purchase price of the property plus any improvements from the sale proceeds. This article explains some of the potential tax issues that may arise relative to the taxation of home flipping profits.
Generally, assets held for investment are taxed as capital gains. Assets held for one year or longer are taxed as long term capital gains, while assets held for one year or less than one year are taxed as short term capital gains.
Long-term capital gains are generally taxed at a lower rate than ordinary income. The tax rate for long-term capital gains ranges from 0% to 20%, depending on the taxpayer’s income level. For example, for the tax year 2021, individuals with taxable income below $40,400 (single filers) or $80,800 (married filing jointly) are not required to pay any taxes on long-term capital gains.
Short term capital gains are taxed at the same rate as ordinary income. The tax rate applicable to short term capital gain is dependent upon a taxpayer’s other income.
Because most taxpayers hold flipped homes for one year or less, the profit from flipping homes is generally short term capital gain, if it can be shown that the flipped property was held for investment.
However, flipping houses can be considered a business. For tax purposes, a business is defined as an entity that engages in activities with the primary purpose of generating income or profit. The Internal Revenue Service (IRS) recognizes several different types of businesses, including sole proprietorships, partnerships, limited liability companies (LLCs), s-corporations, and c corporations.
A sole proprietorship is a business owned and operated by one individual, while a partnership is a business owned and operated by two or more individuals. LLCs are hybrid entities that combine the limited liability protection of a corporation with the tax benefits of a partnership. S corporations and c corporations are both separate legal entities that provide limited liability protection to their owners, but they differ in how they are taxed.
Taxation of a business depends on how the business is organized. Partnerships, s-corporations, and c-corporations are separate entities that are required to file their own tax returns. The net income or loss of partnerships and s-corporations are taxed to their partners or shareholders. The partners’ and shareholders’ share of their income are reported on Schedules K-1. Generally, distributions from partnerships or s-corporations are not deducible by the partnership or s-corporation and are not taxed to the recipient.
LLCs may be taxed as sole proprietorships, partnerships, s-corporations, or c-corporations. Single member LLCs are generally taxed as sole proprietorships, unless the LLC makes an affirmative election to be taxed as a s-corporation or c-corporation. Multimember LLCs may elect to be taxed as partnerships, s-corporations, or c-corporations.
If house flipping is determined to be a business and the houses are determined to be assets not held for investment, the taxation of the profits can be expensive. If the house flipping business is taxed as a sole proprietorship, the profits are taxed as ordinary income. In addition to the income tax, the profit may be subject to self-employment tax. The self-employment tax is 15.3% of the profit.
We generally suggest that the house flippers create an LLC and elect to be taxed as an s-corporation. This allows the profits to be taxed to the shareholder or shareholders and avoid self-employment tax. The issue with using an LLC is that banks or other financiers may not lend to an LLC. The banks or financiers may require that the property be held in the names of individuals. At a minimum, the financiers may require a personal guarantee that requires the individuals to repay the loan should the LLC be unable to repay the loan.
One s-corporation caveat is that officers who provide services to an s-corporation are required to be paid a reasonable salary for their services. The amount of the salary is determined to be the salary an unrelated person would receive for the same responsibilities. The determination of reasonable salary is determined on a case by case basis and is more art than science. Consequently, the savings of self-employment tax is offset by the employment taxes required to be paid on the officer’s compensation.
Whether the house flipping is determined to be an investment subject to taxation as capital gains or is a business taxed as ordinary income is a question of the taxpayer’s intent. If the intent is to repair the property and hold it for rent or other use, it is a capital assets whose sale generates capital gain income. If the home is held for longer than one year, the profit is taxed as long term capital gain.
If the intent of the taxpayer is to repair the building and sell it at a profit, it is a business and may be subject to income taxes and self-employment taxes, depending on how the business is organized. As a practical matter, because most flipped homes sell within one year, there is no difference in the income taxation if the house is treated as a capital asset or a business. The difference lies in the assessment of self-employment tax, absent s-corporation or c-corporation treatment.
Another issue that may arise is the eligibility of the house flippers to use a like kind exchange to defer the taxation of any profits. Only properties held for investment are eligible to be exchanged in a like-kind exchange that avoids current taxation on the profit. If the home flipping is determined to be a business, the gain on the sale or exchange of the home cannot be deferred in a like kind exchange. The rules for like-kind exchanges are complex. Please consult your tax advisor for specific advice applicable to your situation.
As with most things tax related, the law and the rules can be complex. You should seek the advice of a competent tax advisor for guidance.