The Best (& Worst) States for Flipping Houses in 2020

House flipping isn’t for the faint of heart. But you know what makes it a little easier?

Two things:

Knowing where to find the friendliest environments for house flippers.
Knowing how to avoid unnecessary contributions to Uncle Sam.

Let’s talk about the best markets for fix and flips in 2020 and look at how you can limit your tax liability when flipping homes.

Best and Worst States for House Flipping

Which states are “best” for real estate really depends on your criteria. For example, CNBC data show that Pennsylvania boasts the highest ROIs for flipping by percentage (at 164 percent), while Maryland ranks higher in terms of profits in dollar value.

All things considered, however, here are the states considered flip-friendly:

Pennsylvania
Tennessee
Maryland
New Jersey
Louisiana

What about the worst states for house flipping? CNBC’s rankings included these states:

Hawaii
Wyoming
South Dakota
Montana
Mississippi

Best Cities to Flip a Home

If you’re looking for city-specific info, here it is. WalletHub crunched the numbers on 150 housing markets to determine the cities flippers should look into (albeit in 2019—so buyer beware). Items taken into account for placement on this list include health of the general market, average costs of housing and remodeling work, and even quality of life for renters.

The cities where the survey determined the outlook is highest are:

Sioux Falls, South Dakota
Missoula, Montana
Rapid City, South Dakota
Billings, Montana
Peoria, Arizona

How to Use a Self-Directed IRA for House Flipping

With a self-directed IRA, you can flip homes or engage in real estate transactions funded with your retirement savings by simply writing a check. As owner of your self-directed IRA LLC, you will have the authority to make real estate investment decisions without waiting for the consent of an IRA custodian.

In fact, you can make the purchase, pay for the improvements, and sell or flip the property on your own without involving an IRA custodian. All the money you make from flipping houses using a self-directed IRA will be tax-free. However, there are a few things you need to watch out for.

Understanding the Tax Environment for Flippers

Before you test the house-flipping waters in one of the aforementioned cities or states, you should always be mindful of the Unrelated Business Taxable Income rules (also known as UBTI or UBIT).

The purpose of the UBTI and UBIT rules is to make sure those who are traditionally tax-exempt (IRAs, charities, and 401(k)s) are taxed as a for-profit business when they engage in active business activities or use leverage.

The UBTI or UBIT rules generally apply to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations define three phrases: trade or business, regularly carried on, and unrelated.

Trade or Business: The rules start with the concept of “trade or business” listed by Internal Revenue Code Section 162, which limits the term “trade or business” to profit-oriented activities involving the tax-exempt entity.
Regularly Carried On: The UBIT or UBIT rules apply to income of an unrelated trade or business that is “regularly carried on” by an organization. Whether a trade or business is “regularly carried on” is determined by comparing what the tax-exempt entity does to non-tax exempt entities. Basically, tax-exempt entities can’t do things that are deemed “commercial” unless they want to start paying taxes.
Unrelated: In the case of an IRA or 401(k) plan, any business activity will be treated as “unrelated” to its exempt purpose. For IRAs and 401(k)s, a transaction would not trigger the UBTI or UBIT rules if the transaction is not a trade or business that is “regularly carried on.” Activities that wouldn’t trigger UBIT or UBTI include capital gains, interest, rental income, royalties, and dividends generated by the IRA/401(k). The passive income exemptions to the UBTI or UBIT rules are listed in Internal Revenue Code Section 512. But if you, as a tax-exempt entity, engage in an active trade or business—such as a restaurant, store, or manufacturing business—the IRS will tax the income from the business since the activity is an active trade or business that is regularly carried on.

How Do the UBTI/UBIT Rules Apply to Flipping Homes?

By now, you’re probably wondering what kind of real estate transaction will trigger the UBTI or UBIT taxes.

There’s no telling how many houses you have to flip in order to trigger the UBTI or UBIT tax. But the IRS does have a number of factors it will use to determine whether you’ve engaged in a high enough volume of real estate transactions (such as home flipping) to trigger the UBTI or UBIT tax.

3 Factors the IRS Uses:

Frequency The IRS will examine the frequency of the transactions. As in, how many flipping transactions did you do in a given year?
Intention: Were you intending to engage in an active trade or business?
Alternate Activity Patterns: They’ll also look at the other activities you’ve been doing using your 401(k) or IRA to determine whether the activity is part of a business activity (what you don’t want them to think) or an investment.

If it’s determined that an activity/transaction you engaged in is an active trade or business transaction, you will trigger the UBTI or UBIT tax, which is taxed at a rate of approximately 37% for 2020.

One or two flipping transactions per year wouldn’t be considered an active trade or business and wouldn’t trigger the UBTI or UBIT tax. But what happens if you do four or five—or even 10—flipping transactions in a year? Would that be considered an active trade or business causing the UBTI/UBIT taxes to get triggered?

The answer to your question largely depends on the circumstances of your unique situation. It’s all about how and why you flip the houses, not how many you flip. At least, that’s how your friends at the IRS see it.

Savvy investors should note that due diligence is always their responsibility. Some of these factors could change for a variety of reasons at any time, so always conduct thorough research before buying an investment. Get as much information from as many sources as possible, and always have qualified professionals review any deals you engage in.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.