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Flipping Houses: 3 Tax Pitfalls to Avoid

Flipping HousesWith the real estate market finally seeming to have turned the corner, flipping houses is coming back into vogue. Many people are drawn to the idea of buying old or foreclosed houses, fixing them up, and quickly selling them for a profit.

Flipping houses can certainly lead to big bucks. However, there are some important tax aspects to be aware of.

If you’re not careful, a part time flipper could get caught by surprise with a much larger tax bill than expected.

Avoid these 3 major tax pitfalls when you start flipping houses for profit.

Flipping Houses Pitfall #1: Dealer Treatment

There are 2 tax classifications to be aware of when you are in the business of flipping houses:

  1. Real estate investor
  2. Real estate dealer

In short, investors enjoy capital gains treatment while dealers pay ordinary income tax rates. If minimizing taxes is your goal, you want to be considered an investor.

You’re likely an investor if you’re buying just a property or two on the side and selling them once they are renovated. However, if you’re regularly buying and selling properties, the IRS may deem you a dealer – and the tax difference can be significant.

Like many aspects of tax, there is no cut-off for what number of properties makes you a dealer or an investor.

If you’re buying and selling multiple properties per year, you may likely be a dealer. If you primarily buy and hold properties, and only sell a few here and there, you are likely an investor.

However, each case is determined on a “facts and circumstances” basis.

Flipping Houses Pitfall #2: Self-Employment Taxes

If the IRS decides that you’re actually a real estate dealer, your real estate activity is treated as a separate trade or business, and as such the net income is subject to the 15.3% self-employment tax in addition to your ordinary income tax rate.

This extra tax can be a big surprise, especially if you’re like many real estate investors who wait until the last minute to file your tax return.

Flipping Houses Pitfall #3: Short Term Capital Gains

Selling your properties quickly is great, right? Not necessarily, if you’re a real estate investor.

For the person new to flipping houses, this might come as a surprise. The idea – of course – is to fix up your property and to flip it as quickly as possible. That’s not always the case though.

The length of time between when you purchase the property and when you sell it (your “holding period”) is what determines its capital gain rate treatment.

If you do manage to purchase, renovate, and flip a property for a profit in less than a year – you will be subject to short term capital gain treatment on that profit.

Okay, so what’s the difference between short and long term capital gains, you ask? Basically, short term capital gains are taxed at higher ordinary income tax rates, while long term capital gains provide several tax advantages and enjoy lower rates.

If you purchase and hold the property for more than one year, you will get to enjoy long-term capital gain treatment on that sale. The tax savings will likely be significant.

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