House flipping is a valid investment opportunity for people willing to take the risks and put in the hard work necessary to succeed. But there is one thing every new house flipper should know before ever purchasing that first house: flipping can send your tax bill through the roof.
Actium Partners, a Salt Lake City hard money firm that specializes in commercial real estate transactions, explains that a fair number of hard money lenders avoid house flipping projects because they are too risky. They are risky for both lender and investor. But even when all other risks are mitigated, investors are still left with the tax issue. And make no mistake about it, the tax issue is a big one.
Investments and Capital Gains
Taxes in this country are levied in lots of different ways. Some taxes are more creative than others. Take capital gains. Capital gains are essentially profits earned on certain types of investments. If you have a share of stock you purchase for $100 and sell at the end of the year for $110, you have gained $10 on the transaction. You pay taxes on that amount.
The returns on most types of investments are not considered income. Therefore, they are not taxed at income tax rates. They are taxed at capital gains rates. The thing is that capital gains rates are lower than income tax rates.
This is a good thing for property investors, right? Yes and no. An investor who holds on to a property for at least one year will pay the capital gains rate when he sells. Should he turn around and put the profit into a similar investment within a certain time frame, he could avoid the taxes altogether. House flippers do not have that luxury.
Profits Taxed As Income
The key to making good money flipping houses is fast turnaround. Ideally, an investor wants to have a house sold within three months. The average time to complete a flip is six months. That is good for bringing in revenue. It is bad for tax purposes.
Short-term investments, which is to say investments that are held for less than one year, are taxed at a short-term capital gains rate equal to the income tax rate. The reasoning is simple.
Under federal law, house flipping is considered a business. It is no different than buying and selling used cars. Therefore, every dime in profits is considered income. House flippers more or less pay income taxes on their profits. A house flipper making six figures annually is going to pay more in taxes than a neighbor earning just five figures.
A Higher Tax Bracket
Another thing to be concerned about is a higher tax bracket. Let’s say a house flipper was on the upper edge of one tax bracket at the end of 2021. He had an especially good year in 2022, thanks to escalating property values. He earned enough to bump him into the next tax bracket.
This becomes a problem if he has been bumped into the higher bracket by just a few thousand dollars. The higher tax bill could ultimately mean lower total profits despite the investor having a better year on paper.
House flipping is risky just from the standpoint of making a profit. That’s why so many hard money lenders won’t touch it. But it is even more risky from a tax standpoint. Profits from house flipping are taxed as income rather than capital gains. Therein lies the problem. Investors can still make money flipping, but they need to be prepared for higher tax bills too.