Advantage Software LLC   What are the Tax Consequences of House Flipping?
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   House Flipping and Taxes
 
 
  House flipping involves the purchase, renovation and sale of a property, hopefully for a profit, when the improvements are complete.  The object of house flipping is to buy, renovate and sell a property in the shortest amount of time possible with the greatest profit possible.  Investors buy, rent and hold and those who flip buy, renovate and sell.  When you purchase and flip one or more properties in less than 1 year, a good understanding of the tax consequences of your activities is critical.  Your flip profits may be subject to state income taxes, federal income taxes and self-employment taxes.  The tax liability that you incur can be as high as 25 to 55 plus percent.  Taxes can take a big bite out of your profits.  Understanding the tax laws that govern the purchase and sale of real estate will help you to develop tax strategies that can reduce your tax liability and personal liability.  It will be helpful to take a look at some different scenarios and the potential tax consequences.

                                    Flipping Business Strategies

If you are purchasing, renovating and selling properties over and over and will be continuing into the future, the IRS will consider your activities a business and you will be subject to state income taxes, federal income taxes and self-employment taxes.  Self-employment taxes include social security and Medicare taxes.  The self-employment tax rate is 15.3 %, 12.4% for social security and 2.9% for Medicare.  Federal income tax rates can be as high as 35%.  Click on  Federal Income Tax Table  to view federal income tax rates.  In California, an income of 40,346 and over puts you in a 9.3% state tax bracket.  Florida has no state income taxes.  State income taxes can take a substantial bite out of your flipping profits, so be sure to check out your state.  Click on the following link and then your state name to view your state tax rates.  You can click on the back button to return to this article.

  http://swz.salary.com/salarywizard/layouthtmls/swzl_statetaxrate_WI.html

Note:  In 2010, if you are self-employed, the self employment tax rate is 15.3 percent on your first $106,800 of income.  For all income over $106,800, you pay just 2.9 percent which is the medicare portion of the social security tax.  You are not required to pay the 12.4 percent.  You should also be aware that the IRS allows you to deduct half of your self employment tax amount from your gross income on form 1040.

The savvy flip business owner utilizes different strategies to increase profits, reduce taxes and limit liability.  The following is a brief summary of some of the steps you can take to minimize your personal and tax liability and maximize your flip profits.

 
 
     If you are in the business of flipping properties, you should consider incorporating or setting up a Limited Liability Company (LLC) to protect your personal assets.  In both a corporation and a LLC, members or stockholders canít be held personally liable for business debts and lawsuits against the business.  They can only be held liable for business debts if they personally guarantee the debt.  If the business is sued, just the assets of the business are at risk, not the personal assets of the members or stockholders.  Note - The owners of a limited liability company are referred to as members. 

  You can reduce your sales commission expenses by obtaining a real estate salesperson license or a real estate broker license.  Real estate commissions can take a big bite out of your profits.  For example, on a $300,000 property with a 5% sales commission, it will cost you $15,000 to sell your flip property.  Even if you only get a listing commission, it will help your bottom line.  A real estate sales license will give you access to the multiple listing service database where you can locate the selling price of recent sales of similar properties in the area that you are doing your flip.  This information will help you to estimate your potential profit. 

  Keep detailed and organized records for each property that you flip including receipts documenting improvements and miscellaneous expenses, bank statements, transaction settlement documents, etc. that corroborate all costs affiliated with the purchase, renovation and sale of each property that you flip.

  Be sure to keep track of all costs associated with starting up your flip business.  Business start-up costs are considered capital expenditures and they include any expenses that you incur before you actually begin doing business.  The IRS allows you to write-off start-up costs over your first five years of operation.

   You can write-off miscellaneous business expenses including wages and salaries, materials, supplies, business related educational expenses, business insurance, business utilities, business property taxes, business legal fees, accounting fees, business interest expense, business rent, advertising expenses, 50% of business entertainment expenses, business travel expenses, postage, business charitable contributions, bank service charges, business gifts, business related magazines and books, business theft losses, business consultant fees, real estate commissions on the properties that you flip, purchase and sale closing costs, business seminars, trade shows, business internet access, etc.  If you are unsure about the deductibility of a particular expense, check with your tax advisor.

   When you have your flipping business up and going, you can write-off your automobile expenses in one of two ways.  You can keep track of all actual automobile expenses that you incur or you can keep track of all miles driven for business purposes.  The 2012 mileage deduction is 55.5 cents per mile.  Check with your accountant to determine which method will work the best for you.

   If you purchase a building for your flip business, you can write-off your interest expense, utilities, insurance, property taxes, supplies, repairs, maintenance, depreciation, etc.  Commercial buildings are depreciated over 39 years.  Only the building can be depreciated and not the land that the building resides on.

   A small business can write-off a little over $100,000 in personal property purchases in the year of the purchase.  Qualifying Section 179 Property includes office furniture, office equipment, business software, computer equipment, equipment used to renovate your flip properties, etc.  Automobiles are not considered Section 179 property.  Consult with your accountant to determine which assets you can write-off in the year that you purchase them and which assets you will need to depreciate over a given number of years.

    You might want to establish a home office to perform business administrative activities.  You can write-off office equipment, office furniture, business postage, business software, office supplies, etc.  You can also write-off a percentage of your utilities, mortgage interest, property taxes, security system, garbage pickup, repair and maintenance costs, house insurance, depreciation, etc.  Go over your potential home office deductions with your accountant to make sure that you comply with IRS guidelines.

    Set up a 401k or Simple IRA to reduce your tax liability.  If you have no employees and you utilize contractors to do all of your flip property rehab work, I would highly recommend setting up a solo 401k.  Your solo 401K contributions reduce your state and federal income tax liability and your self-employment tax liability.  If you are under 50 years old, you can make a personal contribution of  $15,000 and a business contribution of 20% of your business net income.  Your total tax-deductible contribution canít exceed $44,000.  If you are 50 or older, you can make a personal contribution of $20,000 and a business / employer contribution of 20% of your business net income.  Your total 401K contributions canít exceed $49,000.  The business portion or employer portion of your 401K contributions, the 20% of your net profit, will reduce your federal income tax liability, state income tax liability and self-employment tax liability.  As mentioned above, the self-employment tax rate is15.3%.  Your personal 401K contributions will reduce just your state and federal income tax liability.  Maximize your employer contribution first.  Note:  You are not allowed to deduct the interest paid on money that you borrow from your 401k account as a business expense.

If you have employees, setting up a 401k will be expensive.  You will be required to set up a 401k for each of your employees and to contribute to their accounts also.  You might want to check with a retirement account specialist if you have employees. 

 
 
 
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  If you purchase, renovate and sell a couple properties in a short period of time and then quit flipping, you may be able to avoid paying self employment taxes. Your flip profits will still be subject to state and federal income taxes.  I am guessing that people who fall into this category have tried flipping and it isn't for them or they have successfully flipped several properties and the IRS is knocking at the door.  They decide to get out of it because they have planned poorly and find themselves with a huge tax liability.  Be sure to check with a competent tax attorney to determine how the IRS will view your flipping activities.  If you are flipping properties to earn a living, the IRS will likely consider your activities a business.  If you are in the flipping business for the long haul, set up a business and utilize the tax strategies described above as well as other strategies to limit your tax liability and your personal liability.

Long Term Investing - Purchasing and holding property for more than 1 year.

If you purchase and renovate several properties or more in one year and then rent them out and hold onto them for 1 year or more, the IRS will likely perceive your activities as an investment and not business related.  When you hold property for more than 1 year, your gain is treated as a long term profit and is taxed at more favorable long term capital gains rates.  Investors in a 25% or greater marginal tax bracket are currently taxed at a 15% capital gains rate and a 25% unrecapture depreciation tax rate.  Investors in a 15% or lower marginal tax bracket currently pay a 5% capital gains rate and a 15% unrecapture tax rate.  Special rules apply to investors who qualify for the 5% capital  gains rate.  Check with your accountant if your federal  income tax rate is 15% or less.  If you have the cash, you might want to consider purchasing, renovating and renting out several properties and then refinancing down the road to pull out some of the profits. Click on the following link to learn more about capital gains and unrecapture tax rates.     Capital Gains Taxes

If you have owned an investment property for more than one year, you may be able to exchange the property for a like kind property via a 1031 exchange.  A 1031 exchange allows you to move your gains into a larger investment property or several investment properties and delay paying capital gains taxes. 

                                              1031 Exchange

If you have renovated and rented out several properties, it would be wise to hold them for at least a year before performing a 1031 exchange.  What is a 1031 Exchange?  A 1031 exchange allows the investor to roll their proceeds from one investment property into the purchase of one or more like kind investment properties. Why would you want to do a 1031 exchange?  It allows you to delay paying taxes and to use the equity that you would have paid in capital gains taxes to trade up for a larger investment property.  You can refinance the replacement property once the exchange is complete and take money out to purchase another property.  You canít perform a 1031 exchange on your personal residence or second home.  If you use a 1031 exchange, you canít take possession of the money from the sale.  You must find a qualified intermediary to act as a facilitator.  The facilitator takes possession of the proceeds from sale and uses the funds to purchase the replacement property.  Your contract to sell your current property and your purchase contract for your replacement property must contain wording that clearly states your intent to perform a 1031 exchange.  You have 45 days from the sale of your current property to identify potential replacement properties and 180 days to close on your replacement property or properties.  These are just a few of the rules that impact 1031 exchanges.  The rules governing 1031 exchanges are complicated.  If you are considering a 1031 exchange, be sure to consult with a competent attorney to make sure that you comply with all IRS regulations. 

                                             Personal Residence 

Special tax rules enacted in 1997 apply to the sale of your personal residence.  If you have owned and lived in your primary residence for 2 out of 5 years ending on the date that the property is sold, you qualify for a special tax exclusion.  If you are single, you can make up to $250,000 in profits on the sale of your primary residence and pay no taxes.  Married couples can make up to 500,000 in profits and pay no taxes.  If you sell your primary residence in less than 2 years, you might qualify for a partial exclusionary amount.  You can qualify for a partial exclusion if you sell your primary residence as a result of a change in your place of employment, for health reasons, or for qualifying unforeseen circumstances.  If you will be selling your primary residence after living there for less than 2 years, check IRS guidelines to see if you qualify for a partial exclusion.  A partial exclusion would be calculated like this.  You are married and live in your home for 1Ĺ years before selling it.  Your maximum partial exclusion amount would equal $375,000 or $500,000 times 18 / 24.  That is $500,000 times 18 months divided by 24 months. 

Consider moving into a property and living in it for two years while you renovate it.  This will qualify you for the above tax exclusion.  You can buy and sell a new personal residence every two years and qualify for the above tax exclusion over and over.  I donít consider this house flipping, but it is an excellent strategy that some people use.

This article should not be used as a substitute for consulting a competent CPA or tax attorney to evaluate your individual tax situation.    

                           

 
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