Our guest blogger today is Thomas Castelli, a CPA, Tax Strategist and member of The Real Estate CPA. He shares his insights on how to save a bundle of cash by avoiding common tax traps.
Unlike rental real estate, your flipping activities are considered an active business by the IRS, and not “investments," despite the misnomer of being a real estate investment. Flips are actually taxed as active income at your ordinary tax rate (10-37%), not at the capital gain tax rates (0-20%), and the income you produce is subject to the self-employment tax of 15.3%.
On top of that, you also cannot claim any depreciation deductions or participate in 1031 exchanges on properties that you flip. It is important to be aware of these common tax traps, or it might cost you a bundle. Read on to learn how to avoid them!
Trap #1 - Planning to Pay Tax at Capital Gains Rates
As mentioned above, if you are a flipper, you are taxed at ordinary tax rates and not the favorable capital gains rates rental real estate owners enjoy.
Rather than being labeled investors, flippers are considered dealers of real estate. Properties purchased as flips are considered inventory, which is taxed as ordinary income.
You will want to keep your ordinary income tax rate at top of mind when making profit projections, as this rate can very easily be substantially higher (22-37%) than the common capital gains rates (15-20%).
Trap #2 - Including Depreciation in Projections
Owners of rental real estate get to deduct a non-cash expense called depreciation. Flippers, on the other hand, do not.
That's because in a flipping business, houses are not considered investment property, but rather inventory, and inventory is not depreciated.
If you are including depreciation in your projections, go back and take it out to make sure the deal is still profitable without it. Otherwise you could end up with a lower than expected profit, or even a loss.
Trap #3 - Relying on a 1031 Exchange as an Exit Strategy
1031 Exchanges allow rental property owners to exchange one property for another by deferring the capital gains tax and utilizing the entire sales proceeds to purchase the new (usually larger) property.
To qualify for a 1031 exchange, a property owner must have the intent to hold the property as an investment, and not for resale. And if you are considered a dealer of real estate, the IRS already knows your intent.
With that in mind, you shouldn’t be relying on the benefits of a 1031 exchange to make a potential flip profitable.
Trap #4 – Paying too much Self-Employment Tax
The self-employment (SE) tax is a whopping 15.3% on the first $118,500 of earnings, ouch!
Flipping is considered an active business and is subject to the SE tax, but there is a powerful strategy to mitigate this tax that many flippers have never heard of, or simply never implemented.
This strategy involves establishing an S-Corp or an LLC taxed as an S-Corp. S-Corps allow taxpayers to break down their income into two categories - salary and distributions.
Salaries are subject to the SE tax while distributions are not. As a flipper, you will determine a reasonable salary for your role in the business and have the rest of your earnings classified as distributions.
It is important to note that you will want to set your wage as low as possible while still being able to justify it as reasonable. The IRS will not allow you to pull the "Price is Right" strategy and set your wage to $1 to completely avoid this tax.
Joe is a flipper with profits of $170,830 for the 2018 tax year. If he were simply a sole proprietor, then all of his income would be considered wages, and up to $118,500 would be subject to the 15.3% SE tax – totaling $18,130.50.
However, if he were to set up an LLC and elect to be taxed as an S-Corp, he can split the earnings between salary and distributions. With the help of his CPA, he might determine $65,000 to be a reasonable salary. This means that he will only pay the SE tax on $65,000, saving $8,361. Not bad!
The Bottom Line
Flipping houses is not taxed the same as rental real estate, and understanding the key differences can be the difference between a profitable project or going bust.
With the help of your tax adviser, you should be able to come up with a plan to factor these taxes into your investment decisions and mitigate these taxes whenever possible!
About the Author: Thomas Castelli, CPA is a Tax Strategist and member of The Real Estate CPA, an accounting firm that helps real estate investors keep more of their hard earned dollars in their pockets, and out of the government’s, by using creative tax strategies and planning. You can find him on LinkedIn.