Fix-and-flip properties are a lucrative addition to any investment portfolio, but investors must understand the tax considerations before purchasing their first property.
Unlike long-term investments such as rental properties, fix-and-flip properties generally aren’t offered the same tax benefits.
However, there are still several methods fix-and-flippers can use to help reduce their taxes.
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What are the tax considerations for a fix-and-flip project?
If you’re considering flipping homes, your first step should be to consult with an accountant and attorney who can help you dive into the financial specifics of your investment.
Being proactive about your financial situation, potential income, and the tax laws in your state will make the entire process much smoother.
In general, the following aspects of your investment will determine how the IRS approaches your scenario:
- Are you a real estate investor or dealer?
- How long will you have the property?
- Is the property your primary residence?
- Do you have an LLC?
- What expenses can you deduct?
Real estate investor vs. dealer
The IRS classifies real estate investors and real estate dealers differently.
While fix-and-flip properties are generally considered a type of real estate investment, the IRS classifies house flippers as real estate dealers rather than investors.
A real estate investor purchases properties intending to hold them for the long term, aiming for appreciation and rental income.
On the other hand, dealers buy and sell properties with the primary purpose of making a profit.
Short-term vs. long-term capital gains
Fix-and-flip projects usually generate short-term capital gains, which are profits on assets that are held for less than a year.
Short-term capital gains are taxed as ordinary income, which means they are subject to the standard income tax rates.
Real estate investors can benefit from more favorable tax rates on long-term capital gains, which are for profits on assets that are held for more than one year.
House flippers also must pay self-employment tax at 15.3%, and they can’t take advantage of the following real estate tax benefits:
- 1031 exchange: Properties bought for resale are excluded
- Section 121 exclusion: Requires the home to be your primary residence
While it may seem like fix-and-flippers can’t catch a break when it comes to tax season, there are still ways you can reduce your tax burden.
How to reduce the amount of taxes you’ll pay as an investor
The following strategies can help reduce the amount of taxes you’ll pay as a fix-and-flip investor.
Flip your primary residence
If you’re new to the world of house flipping, it may be a useful strategy to start by flipping your own home. Not only will this help you get a feel for how renovations go, but you’ll also get a special tax benefit.
By flipping your primary residence, you can take advantage of the Section 121 exclusion.
The 121 exclusion allows homeowners to exclude a portion of the capital gains from the sale of their primary residence from taxable income, up to $250,000 for individuals or $500,000 for couples filing jointly.
To qualify, you must have lived in the property for at least two of the five years leading up to the sale.
Start an LLC
Forming a Limited Liability Company (LLC) for flipping homes can offer several tax advantages, including deducting business expenses.
Consult with your accountant and attorney for specifics, because LLCs are state-governed.
Diversify your portfolio
Diversification is not only a risk management strategy but also a tax planning approach.
By spreading investments across different types of real estate or asset classes, investors can optimize their tax position.
This may involve opportunities in residential or commercial properties, each with its unique tax implications.
It also may include private mortgage real estate investment trusts (mREITs), which allow you to invest in real estate without having to personally purchase or flip properties.
Make deductions
House flippers should maintain detailed documentation of all business expenses, because they may be deductible at tax time.
Examples of potential deductions include your office rent and utilities, office supplies, accounting and legal fees, loan interest, and travel expenses.
Your accountant can help you determine the exact expenses you can deduct when you file, any potential capital losses, and the capitalized costs you’ll have to wait to deduct until the house is sold.
Tax advantages of the Marquee Investor Capital Fund
Fix-and-flip projects can be just one part of a diverse investment portfolio.
A healthy real estate portfolio includes a mixture of physical properties, such as rental properties and fix-and-flip projects, as well as private real estate investments such as private mREITs.
MREITs have a minimal correlation to conventional assets like stocks and bonds, plus the potential for higher returns and inflation protection.
Additionally, they offer numerous tax benefits. Investors are entitled to a Qualified Business Income Deduction earned from trusts, including from REIT dividends.
Marquee Funding Group’s Capital Fund 1 elects REIT status to deduct 20% of qualified REIT dividends from income tax returns, so investors only pay taxes on 80% of dividends earned.
Marquee’s Capital Fund 1 is essentially an mREIT that holds mortgage-backed securities collateralized by real estate.
Start investing with Marquee Funding Group today.
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Whether you’re seeking funding for your next investment property or want to invest without the headaches of maintaining physical properties or tenants, Marquee can offer fast, flexible solutions that fit your unique scenario.
If you’re new to private money lending or have questions about the process, don’t hesitate to reach out to the Marquee team.
We specialize in challenging or unusual real estate transactions that institutional lenders refuse to do.
To take the next steps with your investment property, submit your loan scenario for a fast review from our expert team.
We look forward to partnering with you for all of your real estate investment needs.
Photo by David McBee