Realtor · PHX AZ · Member since 2017 · 48 posts · 20 votes
I am constantly warned about tax penalties due to selling a house you flip. I created an LLC that I'm going to use to invest in and flip houses. I was under the impression that only the money taken out as a draw would be taxed at the highest rate and that the rest would be shielded as long as it is rolled over into the next deal. My plan was to use the proceeds from a flip to do two things. One to help fund the next flip and two as down payment on a small multi family. any guidance or suggestions would be appreciated. thanks.
ok so why do so many people flip houses? I am the only member of the LLC and I have structured it to be a totally separate entity. However, yes once there is a profit then I would want to pay my self something. But the rest would be used to fund the next deal. Also, if I only currently have one primary residence then I could make the flip my secondary residence while it's being rehabbed? ...but even then i need to hold it for 2 years?
People flip houses because they like the big buckets of cash they can make, and rarely think about the tax implications. And if they do think about the tax implications, they decide that it's worth it to generate the big buckets of cash.
You can pay yourself any time you want, and you can do whatever you want with the profits, but that doesn't change the fact that there is a taxable event at the time of sale. So, I would suggest putting aside some of the profits for taxes, or even paying quarterly what you owe.
There is no tax exemption for a "secondary residence," so there's no benefit to holding a property for 2 years if you're not living in it as your primary residence.
Unfortunately, your impression is not correct. Assuming the LLC is structured as a partnership or an S-Corp for tax purposes, the income earned will flow through to you personally and will be taxable at the time it is earned. You can't simply roll the profits into the next deal and avoid paying taxes. You will have a taxable event at the time the profits are earned (the property is sold), most likely at your ordinary/marginal rate, plus some degree of self-employment taxes, depending on how the LLC is structured.
Nope. No government would fall for that. You owe the tax when the income is made. And flipping is taxed at the highest possible rate for you personally.
Either move in to the house as you rehab / flip it, and hold for two years. Rehab it and turn it in to a rental then do a 1031 in to another property. Or pay big taxes. Don’t forget to pay estimated taxes quarterly, don’t try to pay it at year end or you’ll face a penalty on top of taxes. You may also be subject to self employment taxes or the Medicare surcharge tax. Good questions for your cpa.
Ps. If the llc is truly independent (s or c not disregarded) then you add extra taxes to yourself as you withdraw the money. That part is true.
ok so why do so many people flip houses? I am the only member of the LLC and I have structured it to be a totally separate entity. However, yes once there is a profit then I would want to pay my self something. But the rest would be used to fund the next deal. Also, if I only currently have one primary residence then I could make the flip my secondary residence while it's being rehabbed? ...but even then i need to hold it for 2 years?
Ps. If the llc is truly independent (s or c not disregarded) then you add extra taxes to yourself as you withdraw the money. That part is true.
Great response, though I'll disagree with this one point... An LLC taxed as an S-Corp is still pass-through, and will not incur extra taxes as money is taken from the LLC. In fact, you might save on part of the employer side of the FICA taxes by using an S-Corp election.
ok so why do so many people flip houses? I am the only member of the LLC and I have structured it to be a totally separate entity. However, yes once there is a profit then I would want to pay my self something. But the rest would be used to fund the next deal. Also, if I only currently have one primary residence then I could make the flip my secondary residence while it's being rehabbed? ...but even then i need to hold it for 2 years?
People flip houses because they like the big buckets of cash they can make, and rarely think about the tax implications. And if they do think about the tax implications, they decide that it's worth it to generate the big buckets of cash.
You can pay yourself any time you want, and you can do whatever you want with the profits, but that doesn't change the fact that there is a taxable event at the time of sale. So, I would suggest putting aside some of the profits for taxes, or even paying quarterly what you owe.
There is no tax exemption for a "secondary residence," so there's no benefit to holding a property for 2 years if you're not living in it as your primary residence.
Yeah, this concept of "reinvesting" the profits "save you from paying taxes" is prevalent, but isn't true. If you have profit, in this case buy low sell high, then you have tax. For example, you can't take your day job's salary/income and invest it in SOMETHING and not pay taxes on your income... "reinvesting money/profits" is just a how people "talk," but has nothing to do with how you are taxed.
LLC's are legal entities to provide limited liablity protection if operated properly. They don't provide any tax or accounting benefits unless you are investing with non-spousal partners.
As you have been told, flip profits are the most heavily taxed as its considered dealing in inventory and NOT investing in real estate. So, the profit is active, ordinary income taxed at your marginal rate AND you have to pay self-employment tax.
With a single member LLC, you don't really pay yourself. You take an "owner's draw" just signifying/accounting for taking funds out of the LLC. Since pretty much all the entities except for a C Corp are considered pass through entities, the profit/losses are taxed on your own respective tax returns regardless if you take the draw and move funds out of the LLC.
As mentioned, people flip houses because its a way to make money. Most people don't think of the tax implications of their income generation, or even if they do they don't understand it well or correctly. Also, maybe the deal is better suited to flipping instead of holding. Maybe you don't want to be a landlord...
If you purchase the "secondary residence" in your LLC, it will be hard to justify as a "vacation home." Also, part of the cost that many proponents of the LLC don't advertise is that legal entites, such as LLC's, are not eligible for conforming residential loans. So, you'll have to use commercial financing which doesn't care if its your vacation home. And, I don't understand the holding the second residence for 2yr? The sec121 exclusion is the only one i know which has a 2yr requirement and that is only for your primary residence.
You really should consult a qualified professional or two.. Good luck.
LLC's are legal entities to provide limited liablity protection if operated properly. They don't provide any tax or accounting benefits unless you are investing with non-spousal partners.
LLCs with an S-Corp election typically have a potential tax benefit above a reasonable salary (saving the employer side of the FICA).
Good point, but I pretty much disregard this "technicality" on practicality...
S-Corp election does allow you to save on the employer side of self employment (not FICA which is technically the employee side that you see on a paycheck onlyi) above a reasonable salary. However, its generally ill-advised apparently to hold real estate in an entity with a S Corp election because the "Corp-like" aspects make it less tax advantaged --- I don't remember the details but some sort of double taxation or something somehow sometimes comes into play. So, for passive rentals you'd have to have the S Corp entity be some sort of management company for yourself which only generates more administrative overhead and cost. For flips, I GUESS its okay to hold Title...
But, everybody I've talked to personally who has seriously investigated it realized it wasn't worth the effort at all. As an example, lets say you maxed out the SE income and were able to distribute $100k to yourself (nice round number). That is some $9.1k saved. However, there are the legal fees to setup the more complicated structure, the additional tax filing that CPA's charge, the additional overhead and paperwork/reporting required by the S Corp that much is annually sucked up by the S Corp. Meanwhile, this assumes you max out. If you generated incoe level drops, you save even less since your "reasonable salary" stays the same. If notionally saving $5k in tax in what should be a "big game" is a big deal to you, okay, but for most its not worth the headache.. Just my two cents and others who have actually looked into it (actually some of those who actually have done it). As with many things, "everybody else" gets paid, but you the investor/owner. So, I try not to sell people on stuff they don't need...
Isn't it true that if you hold the property for 1 year and 1 day , you would save on taxes. Because your gains won't be considered earned income, but rather a capital gain, which is taxed at a lower rate?
@Mordy Chaimovitz don’t know. Sounds like either a technique to try to call it an investment. still, it’s something to be calculated if the extra carrying costs justify the tax saved…
But, I don’t plan for long flips and don’t try to skirt it that close..
Isn't it true that if you hold the property for 1 year and 1 day , you would save on taxes. Because your gains won't be considered earned income, but rather a capital gain, which is taxed at a lower rate?
No. Flips are considered business inventory, not investments. So, capital gains don't come into play. Regardless of how long it takes to complete/sell them.
Isn't it true that if you hold the property for 1 year and 1 day , you would save on taxes. Because your gains won't be considered earned income, but rather a capital gain, which is taxed at a lower rate?
No. Flips are considered business inventory, not investments. So, capital gains don't come into play. Regardless of how long it takes to complete/sell them.
Oh! What if I buy a property with built in equity because I got a good price and then rented it out for a year. Is that considered and investment after 1 year, or inventory?
Isn't it true that if you hold the property for 1 year and 1 day , you would save on taxes. Because your gains won't be considered earned income, but rather a capital gain, which is taxed at a lower rate?
No. Flips are considered business inventory, not investments. So, capital gains don't come into play. Regardless of how long it takes to complete/sell them.
Oh! What if I buy a property with built in equity because I got a good price and then rented it out for a year. Is that considered and investment after 1 year, or inventory?
As long as your intent was to hold it as an investment, it's subject to short/long term capital gains rates.
But, IRS will look at your original intent. And if they believed your intent was to flip it after renting it for a year (to get favorable tax treatment), they could treat it like a flip. So, don't let the IRS see this post... ;)
Note that I'm not a tax professional, but I've dealt with these issues quite a bit. So, don't rely on what I say...
@Mordy Chaimovitz yes, @J Scott is pointing out the irs determination is based on facts and circumstances as I was told a while ago. So it’s not that simple…. Definitely consult a qualified professional or two..
Use the. LLC as it is the easiest and cheapers way. LLc and s Corp is about liability not taxes. You make a profit you are going to pay roughly 30%. So just put nit in a savings account after every deal. Multiple llc,s can be owned by a s Corp. Layers of protection from lawsuits. Any house in the llc would be subject to a lawsuit from any house. That is why most have a separate llc for each.
Isn't it true that if you hold the property for 1 year and 1 day , you would save on taxes. Because your gains won't be considered earned income, but rather a capital gain, which is taxed at a lower rate?
No. Flips are considered business inventory, not investments. So, capital gains don't come into play. Regardless of how long it takes to complete/sell them.
Oh! What if I buy a property with built in equity because I got a good price and then rented it out for a year. Is that considered and investment after 1 year, or inventory?
As long as your intent was to hold it as an investment, it's subject to short/long term capital gains rates.
But, IRS will look at your original intent. And if they believed your intent was to flip it after renting it for a year (to get favorable tax treatment), they could treat it like a flip. So, don't let the IRS see this post... ;)
Note that I'm not a tax professional, but I've dealt with these issues quite a bit. So, don't rely on what I say...
Amazing how much I learn from you guys every day. J I keep your article on analyzing deals on my desk and reference it all the time. Thank you!
As far as my intent. I got the houses at under market value. I bought them as investment properties. I hope to make money off of the sale at some point in the future but right now I am renting them out. My intent was to make money for myself and my investor. It's not a flip as I bought them almost turn key. It's an investment.
Exit strategy to be determined based on market rents and market value for a sale, as well as determining if the equity in the houses would perform best where its currently sitting, or in a different investment. Also would need to decide if a sale is more appropriate or a refi.
@Kevin Maher this maybe business school stuff… but S Corp is nothing more than an elected tax status. So a S corp by itself doesn’t really own anything, the underlying entity does…
Yes ill need a cpa. But we're just talking. With that what about deductions. Anyone able to use the purchase price, labor and materials, interests on loans to deduct from tax burden on a flip?
Yes, discuss with your cpa. Yes your rehab costs, loan interest, closing cost (not the prepaids all go towards increasing your cost basis. Don't forget to pay your estimated taxes...
If you want to avoid taxes, don't sell or die are pretty much the only options.
You can defer taxes using a 1031 Exchange. But that's because you never actually receive any proceeds, and they get reinvested into another investment property.
I'm sure there are plenty of places to dig in on 1031s.
@Mordy Chaimovitz, There is a moment when you "put your property into service" that you'll want to watch out for. You may buy a property and hold it for a year. But you've been improving it for all of that year. Same as with a builder who buys a lot and takes 18 months to build a house. That property will not be a capital gain even though it was owned for more than a year. Because it was not in service for a year. And as others have said, your intent must have been to hold for productive use. and you'll want to be able to demonstrate that if ever questioned. And of course, if you're going to hold it long enough that you feel good with capital gains treatment then why not 1031 it. And keep all the tax deferred.
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