Flipping - Taxes

20 Replies

I might be missing something but when I do calculations for potential flips, such as 70/30. The numbers work, but when I take into account taxes I would have to pay on my gross profit (purchase price - sale price) it does not make sense to flip. Any help would be greatly appreciated!

Taxes are based on your net income, which is less than sale - purchase.  More like sale - sales costs - costs of rehab - purchase costs - purchase costs.  Costs of rehab includes any money costs, too.  But once you get to that taxable income number then, yeah, you pay federal, state and local taxes on it, just like income from a job.  And you have to pay both halves of SET (self employment tax.)

Jon Holdman, Flying Phoenix LLC

Thanks so much for your fast post!

I am not a tax expert, but I am going through this right now with my CPA. 

Jon is correct in that you pay taxes on your NET income, not your GROSS income. In other words, you subtract out all costs associated with the acquisition, rehab and sale of the property. The taxes are still quite high since you have to pay income tax and self employment tax on the net profit. 

A good way to shield some of that self employment tax is to set your business up as an S Corp and pay yourself a salary. Then, you only have to pay the self employment tax on the salary you give yourself. You do still have to pay income tax on all of the profit.

Like I said before, I am no expert and you should consult with an accountant before making any decisions on how to structure your business.

Depending on your personal situation, the S-corp approach may or may not be useful.  You're still required to pay yourself a "reasonable" salary and that's still subject to SET.  So, if you're making a lot doing flips, enough to cover the reasonable salary and then have money left, it will help.

Also keep in mind that social security, which is the biggest chunk of SET, is capped.  Only income under about $100K is subject to this tax.  So, if you have a good-paying day job, you may be close to or over that threshold.  That means additional income, such as from flips, won't be subject to social security tax.

Jon Holdman, Flying Phoenix LLC

Derek,

Based on a comment you left on one of my blog posts, I think you might be missing something here.  Let me provide an example:

-  You purchase a house for $50K

-  You spend $40K rehabbing it

-  You spend $10K on taxes, insurance, utilities, loan costs, etc

-  You sell it for $150K, but you only get $140K check at closing because you spend $10K on commissions and closing costs

In this example, you earned $150K (gross income), but spent $50K + $40K + $10K + $10K (total of $110K) on cost of goods sold (in other words, your expenses).  So, your "profit" on this deal, pre-tax, is $40K.

On that $40K you will pay taxes, so your profit will be reduced by some amount.  Most likely that tax amount will be between 15-50% of the $40K, depending on your entire tax situation, so you can expect to walk, after taxes, with about $20-35K.

You are correct that any tax is based on the "net" profits of the flip.  However, some flips can be taxed as capital gains.  It just depends on the circumstances.

People who buy and sell (or “flip”) real properties often call themselves real estate “investors”. But this may not be a correct definition in the eyes of the IRS. The IRS will often seek to determine whether these taxpayers are operating as “dealers” or “investors”. Should you be classified as a dealer, you are deemed to be in an active trade or business and will be taxed at ordinary income rates plus self-employment tax.

When you look at how the IRS examines a "dealer" one of the most important issues appears to be the taxpayer’s volume, frequency and consistency of real estate sales. Said differently, if you have a history of selling a lot of properties and do not have other business activities then this may weigh in favor of you being a dealer.

But just because the IRS may consider you a dealer with respect to a property or certain properties, it may not make you a dealer on all of you properties. It may be advantageous to have certain flips grouped in one taxable entity (for example an LLC possibly taxed as an S Corp) and have "buy and holds" in a separate entity.

You should really discuss the situation with your CPA so that you have a tax plan that is consistent with what you are trying to accomplish.

Medium smallsf1 300x76Paul Sundin, CPA, Sundin & Fish, PLC | [email protected] | 480‑361‑9400 | http://www.sundincpa.com

The taxable Social Security income is on earnings of up to $118,500 in 2015. There are some other new medicare taxes that will apply above 200,000. If you get to that amount it is definitely accountant territory. Here is a short summary:

http://www.shrm.org/hrdisciplines/compensation/articles/pages/fica-social-security-tax-2015.aspx

I would say if you are flipping that much net it likely is a job for you. Not sure how you make flipping a capital gains item without increasing your costs a lot for holding. Taxes should hopefully leave some properties profitable.

  

I've never seen a "flipper" get capital gains treatment on their property.  I'm interested to know what that looks like.

My clients who both "flip" and "hold" have two entities.  One for the flipping and one for the holding.  The strategy when implemented correctly is a thing of beauty.  

Originally posted by @John Briggs :

I've never seen a "flipper" get capital gains treatment on their property.  I'm interested to know what that looks like.

My clients who both "flip" and "hold" have two entities.  One for the flipping and one for the holding.  The strategy when implemented correctly is a thing of beauty.  

 Agreed.  And agreed.  That's been my experience as well...

I read something the other day about a flipper getting capital gain treatment because of their intent and their documentation. Their intent was to hold, and they advertised as a rental, but got such a good offer it made sense to sell. It was all documented well and was their only flip (of many) to be treated as capital gains. 

Could have been a load of crap but still! I read it on the internets so of course it was true! ;)

There is no doubt that as a general rule flips are classified as ordinary income.  But the IRS will typically look to situations cited in related tax court cases.  The IRS looks closely at the “intent” of the taxpayer. Specifically, the following issues are often examined:

  • Purpose for which the original acquisition was made
  • Duration of ownership and the purpose for which it was sold
  • Frequency and continuity of sales
  • The extent to which improvements (if any) were made to the property
  • Control and effort expended by the taxpayer in the sales process
  • Use of real estate brokers and extent of advertising initiatives
  • Ordinary business and experience of the taxpayer
  • Nature of the taxpayer’s other real estate holdings
  • Income from the sale compared to other sources of income and employment
  • Reluctance or desire to dispose of the property

So considering the above criteria, one could look to see if the flip was intentional or unintentional. For example, a taxpayer may have one LLC (or an S-Corp) set up specifically for flips and another set up specifically for buy and holds. He may have purchased a property in the buy and hold LLC with the specific intent to hold it long term, but someone may have come along and made him an offer he couldn't refuse. Even though this may technically be a flip, it does not preclude him from considering capital gains treatment.

You have to understand that this is a very subjective area and each taxpayer's situation is unique.  Also, realize that if the flip is short term it will be taxed at ordinary income rates anyway, so we are just talking about saving employment taxes.  If the flips are going through an S-Corp then there is no employment taxes.  But there could be big savings if a taxpayer had a large capital loss carryover.

The key is to make sure that you discuss your situation with your CPA in advance of the transaction.  

Medium smallsf1 300x76Paul Sundin, CPA, Sundin & Fish, PLC | [email protected] | 480‑361‑9400 | http://www.sundincpa.com

Originally posted by @Paul Sundin, CPA :

You are correct that any tax is based on the "net" profits of the flip.  However, some flips can be taxed as capital gains.  It just depends on the circumstances.

People who buy and sell (or “flip”) real properties often call themselves real estate “investors”. But this may not be a correct definition in the eyes of the IRS. The IRS will often seek to determine whether these taxpayers are operating as “dealers” or “investors”. Should you be classified as a dealer, you are deemed to be in an active trade or business and will be taxed at ordinary income rates plus self-employment tax.

When you look at how the IRS examines a "dealer" one of the most important issues appears to be the taxpayer’s volume, frequency and consistency of real estate sales. Said differently, if you have a history of selling a lot of properties and do not have other business activities then this may weigh in favor of you being a dealer.

But just because the IRS may consider you a dealer with respect to a property or certain properties, it may not make you a dealer on all of you properties. It may be advantageous to have certain flips grouped in one taxable entity (for example an LLC possibly taxed as an S Corp) and have "buy and holds" in a separate entity.

You should really discuss the situation with your CPA so that you have a tax plan that is consistent with what you are trying to accomplish.

 Amen! I just got ripped to shreds for not giving a 4 paragraph answer when my statement was an S-Corp was not ideal for a brand new 1st time property buyer.

I love the fact that you're willing to put so much time and effort into answering questions.

I believe most posters want FREE DETAILED info so they don't need to pay a professional.

Like people who try and diagnose an illness on WebMD. 

Depending on your state and city you can be taxed on the gross proceeds, in addition to the income and SET tax on the net as described above ... even if you lose money on the flip. I know in Los Angeles for example if you are a single member LLC you have to pay not only a state tax on the gross (in addition to the yearly $800), but also a LA city tax on the gross. In addition to that the state requires a 3 1/3% withholding on the gross proceeds from a flip (a withholding, not a tax). So don't assume taxes are always on the net.

@Ron P. that's why I'm not sure why would anybody do a single member LLC?

My way of thinking is, if it's a partnership go for LLC, and if it's one member only, S Corp is better option. One way of the other you need LLC or S Corp when doing flips. Not as much for taxes, but for asset protection

323‑455‑7575 | http://www.RezaReport.com | CA Agent # 01874963

@Ewa Reza  

A SMLLC would be more for holding I would think, and a MMLLC or S-Corp for flipping, as you indicated. For flipping in California, a MMLLC still has to pay the state gross proceeds tax and LA City gross proceeds tax, and $800 minimum state income tax, but avoids the 3 1/3% state withholding on gross proceeds. A S-Corp has to pay LA City gross proceeds tax and $800 minimum state income tax, but avoids the 3 1/3% withholding and LLC gross proceeds tax. Again, all this on top of the state and federal income tax you pay on the net. Keep in mind that depending on one's tolerance for paying taxes these gross proceeds taxes don't amount to much compared to state and federal income taxes on the net.

I say this based on my own experience and what I've read, I'm neither a tax or legal pro.

If you flip just a few times a year and hold at least a year and a day you can probably get away with LT capital gains tax and not ordinary income tax.

I own everything in LLC's. One investment property per LLC.

Flips are in another LLC.

Wow! I'm buying a flip within the next two weeks and I thought I'd learned pretty much everything I'd need to know. I'm partnering with a GC who is an LLC. I believe this is his 1st owned flip but he's been doing the GC work on many other people's projects. Because he's handling the labor, purchasing, subs, etc we are investing $$$$$ equally but splitting the profit 60 - 40 to his advantage. I'm wondering how will need to address the tax situation since we are purchasing the property in the name of the LLC only?????? Any ideas or suggestions?