Three ways to flip a house, but not flop the taxes
Over the years, the reputation of house flippers has improved from people who may or may not do quality work, to people whose expertise could result in a property that boosts neighborhood property values. With many house flipping TV shows, some people might even get inspired to start their own business of flipping houses. In addition to knowing where the hot flipping markets are, what to look for in a house and how to get the work done, it is important to understand how taxes factor into the business equation.
Flipping a house often means becoming a small business owner, which adds a level of complexity to most people’s tax situation. A new house flipper needs to realize there are three basic things to keep in mind; what it means to be self-employed, how to treat this venture like the business it is and track expenses, and what a loss or a profit will do to a tax outcome.
Know the rules for being self-employed
Among the things for new house flippers to know is that they now own a business and they need to learn how to manage being self-employed. Here are some things to keep in mind:
- As the owner of an unincorporated business, income and expenses associated with this business should be reported on Schedule C or Schedule C-EZ with Form 1040
- Estimated income and self-employment taxes are due quarterly in April, June, September and January (self-employment taxes apply for those who make $400 or more in net profit annually)
- If there are other employees in the small business, the owner must pay must pay employment taxes, including unemployment tax and Social Security and Medicare taxes and must withhold and remit federal income tax and the employee portion of Social Security and Medicare taxes.
Also, the expenses of operating a business can directly offset income as tax deductions.
Track business expenses
Because the house to be rehabbed is not the owner’s personal residence, the usual deductions, such as mortgage interest and points paid to borrow money to buy the property aren’t claimed as itemized deductions. Instead, they are capitalized and deducted in the year the home is sold.
All ordinary and necessary rehab expenses are tax deductible, which could include supplies, labor costs, fees for permits and professional services (e.g., fees for real estate agents, lawyers and bookkeepers). Keep track of invoices and receipts for these expenses and of business-use asset information (cost, date placed in service, etc.) for depreciation.
Use of a personal vehicle for business purposes is also deductible. Keeping a log of the purpose, length and date of those trips can serve as proof in case of an audit.
Costs associated with a home office are eligible tax deductions when the taxpayer uses the area exclusively and regularly for conducting their business.
Understand the bottom line
In addition to understanding how to file tax returns as someone who is self-employed, house flippers also need to know how to track their profits and losses.
Basically, if the price paid to purchase the house plus what was spent to improve it are less than what the property is re-sold for, a profit has been made. A loss happens if what was paid for the property plus how much was spent to improve it are more than the re-sale price.
When a taxpayer sustains a loss from an activity year after year, the IRS may consider the “business” to be a hobby. The taxpayer’s profit motive, expertise, time devoted to house flipping, and other factors are all considered to determine if the activity is a business or hobby. Hobby income is reported on Form 1040 and expenses are deductible only up to income as miscellaneous itemized deductions subject to the 2 percent of adjusted gross income limitation.
Also, some taxpayers occasionally buy and sell houses or other real estate as an investment rather than as a business. Facts and circumstances, including the number and frequency of houses bought and sold, the taxpayer’s involvement in any rehab decisions, and the taxpayer’s intent determine whether the activity is an investment.
As with any business, it is important to understand the business itself and the financial side of the endeavor, which includes taxes. So before making big business decisions consider the money end and if needed, get professional advice on the potential tax situation.
By Teresa L. Clark
Teresa L. Clark came to H&R Block in January 2010 after working as a civil servant for more than 13 years. Since that first tax season she has written blog posts and talking points, edited content of all shapes and sizes, facilitated media interviews for the experts in The Tax Institute at H&R Block and supported the DIY team. Clark has a master's degree in integrated marketing communications from the University of Kansas and is a member of the Honor Society of Phi Kappa Phi.