The Potential Flops of House Flipping

By Mike Geeslin, CPA

The rise of HGTV has given us many things – subway tile, tiny houses, 1,000 shades of gray and hearing “open concept” mentioned every twelve seconds. The most recent trend to move from television to the real world is house flipping. If two people can buy a rundown house, fix it up and sell if for three times as much as invested (all in one hour!), why can’t I? We are not here to say that you can’t, but there are several things to consider before buying a house, toolbelt and counting your profits. Some of these considerations are practical, but what we really want to discuss are tax and financial issues surrounding house flipping.

To begin with, let us assume that you have all the requisite knowledge and skill to identify an undervalued, but promising property, purchase it, remodel and sell it all within a limited budget and time constraint. If all of these things are true, you are in a good position to keep moving forward with this venture. If you do not, you are not precluded from house flipping, but may need to pay for some help with the process. All of these issues are things to be considered in another (and much lengthier) post best left to real estate experts.         

In addition to the practical issues of flipping a house, you should consider the tax consequences of property investment. When budgeting for taxes, it is vital to consider the length of time the house will be owned before selling. The goal of most flippers is to purchase a house, fix it and sell it as quickly as possible. A shorter ownership period limits mortgage payments on the property, which is positive, but if the house is owned for less than one year the profit on the sale will typically be taxed as short-term capital gains using the ordinary income tax rates. This can be as high as nearly 40% of any profit made on the sale!

If a house is held for more than a year, the seller’s profit on the sale will usually be taxed at the more favorable long-term capital gains rate. This rate can be as low as zero percent, but also is maxed out at 20%. For example, if a property owner has a normal tax rate of 28%, their long-term capital gains would be taxed at only 15%, which is a tax savings of $13,000 per $100,000 of profit.

If you successfully flip one house, that property is considered an investment and each sale will be taxed between zero and 40%, based on the length of ownership, as previously shown. However, if your talents allow you to become a serial flipper, the government may consider this to be your business, rather than investment, eliminating the lucrative capital gains tax benefit. Being classified as a business subjects you to 15.3% self-employment tax in addition to the ordinary income tax on each sale. With all this in mind, a professional house flipper could be paying up to 55% in taxes for every sale!

An alternative to the quick flip method that is so frequently captured on television is to live in the purchased home while it is renovated and sell it after two years. If a homeowner has lived in a home for two of the last five years, the IRS allows an exclusion of up to $250,000 from taxable income for a single taxpayer and $500,000 if you’re married filing jointly.

In this scenario, a house purchased and lived in for two years and sold for $250,000 profit would result in the seller having zero tax liability on the $250,000 profit. However, if the home was purchased and flipped in less than one year, the after-tax profit could be cut in half by taxes!

Flipping houses can be a very lucrative hobby if undertaken with the correct knowledge and opportunity. Before you choose between “Agreeable Gray” and “Elephant’s Breath” for that rundown house at the end of the block, take a few moments to consider the tax consequences of how you choose to structure this new project.

If you have any questions about the tax impact of your home sale, self-employment tax or any other tax issue, please contact Geeslin Group. If you have questions about retiling a bathroom, we would suggest looking elsewhere.