A common method of investing in real estate is doing a flip. For the purposes of this article, there are basically two types of flips. You can buy a house wholesale and immediately flip it to another investor for a small profit. Or you can rehab a house that you purchased cheaply and sell it at retail. In both instances, the goal in the investor’s mind is to hold the property for a fairly short period of time, usually less than one year.
The challenge in this situation is that unless creative tax strategies - like a 1031 exchange - are followed, you will pay taxes on the gains at the highest rate allowed in the tax codes.
Let’s take a few minutes to examine the three levels of taxation that can affect a flip type house situation and then talk about strategies that may be appropriate to maximize your after tax return on investment.(And as always, it is best to discuss any scenario with your accountant to be appraised of the most current tax laws as they affect your particular situation.)
There are three tax scenarios for buying and then selling a property in a specified period of time.
The first scenario is for a buy/sell cycle that runs for less than one year. If you purchase a house and then resell it before one year passes, your profits will be assessed at the short term capital gains rate. Short term capital gains rates are the highest amount you will pay in taxes on your profits.
The second scenario is where you have owned the property for more than one year. In this instance, you will pay taxes based on the current long term capital gains rate. This rate is generally significantly less than the short terms capital gains rate.
The third scenario is the best. If you are dealing with an owner occupied property - such as a flip where you live in it and make the repairs - you can keep all your profit tax free. It is required that you own and live in the property for at least two years out of any five year period. (This means that if you live in it during the first 24 months of ownership, you are elibible.) If you can meet this scenario, you can keep up to $500,000 in profit if you are married or $250,000 in profit if you are single. And this money is tax free.
After reviewing these three scenarios, you can tell that the best scenario from a direct profit standpoint is the last scenario. And if you are the type who wants to live in the house you are fixing and wait two years before selling, it is certainly a powerful tax benefit. If you choose the right house in an area of rising property values and add value to the property, you can earn a significant amount of profit in two years and enjoy it tax free when you sell the property. It certainly makes a huge nest egg for your next property purchase(s).
The only problem is that you can do this on only one house at a time. So if you plan on flipping more than one house every two years, chances are very high that you will be encountering one of the first two scenarios on every deal.
If you are wholesaling properties - just flipping to another investor for some fast cash - you will always fall into the first category. And in this instance, that is ok. Your goal as a wholesaler is constantly making your money work for you. If it sits in a house too long, it costs you momentum and profits. You are earning your profits on the volume of properties you are flipping and while you certainly care about the tax consequences, you view them as a cost of doing business.
People who rehab houses to sell at retail have a more difficult decision to make. If you can rehab and resell a house for very quickly to get your money working for you again, it probably makes sense to take the hit on taxes that you encounter when you pay short term capital gains because you have your money back and working for you again. Again the tax on the profits is just a cost of doing business.
But some rehabs take longer. Or the profit in the house is very large. In these instances, you need to calculate the cost of holding the house until one year has passed vs the additional tax liability that is created from selling it before one year passes. In this instance, you may choose to just hold the house empty until you can sell it for maximum profit. Or you may choose to do something creative in the sales process and either rent it out for a while (knowing that you will have to polish up the house before final sale) or offer it for sale via a lease option. Either technique will stretch the length of time that you hold the house, help cover the costs of that holding period (or even put profit in your pocket) and let you get that preferential tax rate when you finally sell the property.
Understanding and applying the current tax laws to your real estate transactions is an essential piece to understanding the total profit picture of a deal. If you don’t understand them and plan for them, you could be in for a very large surprise tax bill at the end of the year - one large enough to cripple your real estate investment activities for a long time. Your best resource for understanding the tax ramifications of any investment is your real estate savvy accountant. You should have a person like this on your investment team to be sure you are maximizing your cash flow. If you don’t you could be losing $1000’s of dollars you didn’t have to lose.
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