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Do You Have to Pay Capital Gains Tax When You Flip a House?

If you're planning to get into the fix-and-flip business, don't forget about the IRS.

Apr 02, 2021 by Matt Frankel, CFP
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Flipping houses can be a great way to make money in real estate for investors with the time and knowledge to do it right. And that's especially true in hot real estate markets like those currently in many areas of the United States.

However, it's important to keep in mind that profits from flipping a house aren't all yours -- if you have a profitable flip, the IRS is going to want its share. With that in mind, here's a quick guide to the capital gains taxes you may have to pay when you flip a house and what it could mean to your bottom line as a real estate investor.

Do you have to pay capital gains tax when you flip a house?

The short answer is "maybe." If you have a profit on a house flip, you can be fairly certain that the IRS will consider it to be taxable. But the type of taxable income depends on the situation.

In most cases, house-flipping profits are considered ordinary income, especially if you repeatedly fix and flip houses for profit, or if you have several projects underway at the same time. Ordinary income is subject to tax according to the tax brackets in place for the tax year in which the sale is finalized.

On the other hand, there are some cases when house flipping proceeds can be considered capital gains. If a fix-and-flip is completed from start to finish (closing of the purchase to closing of the sale) in a year or less, it would be subject to short-term capital gains tax.

Short-term capital gains are taxed according to the same tax brackets as ordinary income, but there's one big difference, which we'll get into in the next section. In cases where it takes more than a year to complete the flip, gains can be considered long-term capital gains, which are subject to lower tax rates.

The general idea is that if fixing and flipping homes is a business activity for you, your profits will be treated as ordinary income. For example, if you fix and flip one house, it's much easier to make the case that you have a short-term capital gain than if you complete several flips within a year. The same can be said if you don't have any direct involvement in your fix-and-flips (you are a silent partner).

Capital gains tax is generally meant to apply to passive investment activities, not active business income, so if you can make the case that you're a truly passive investor, you might qualify for capital gains tax treatment.

Of course, there are exceptions to all of this. For example, if you buy the house you're flipping through a self-directed IRA or 401(k), it typically isn't subject to taxation until you withdraw the money from the account. And if you flip a house you actually lived in for a while, it could even be classified as a principal residence in the eyes of the IRS and qualify for the principal residence exemption. But for the most part, house flipping proceeds are typically classified either as ordinary income or short-term capital gains.

Will you have to pay self-employment tax?

You might be wondering why the distinction between ordinary income and short-term capital gains. After all, both types of income are subject to the same tax brackets -- in other words, if your marginal tax rate in 2021 is 28%, that's what you'll pay on both types of income.

The difference is that ordinary income is also subject to self-employment tax, which covers Social Security and Medicare taxes. For 2021, the self-employment tax rate is 15.3% on earned income up to $142,800 and 2.9% on any income beyond that threshold. So, self-employment tax can add quite a bit to your tax bill.

To illustrate the difference that tax classification makes, let's say that you have a $40,000 profit on flipping a house and you're in the 28% marginal tax bracket (which corresponds to a 15% long-term capital gains rate). We'll assume your earned income for the year is less than the $142,800 threshold.

Tax Classification Tax Amount
Long-term capital gain $6,000
Short-term capital gain $11,200
Ordinary income $17,320

As you can see, the tax classification of your profit can make a big difference.

Don't forget about state taxes

It's also worth mentioning that this discussion only pertains to federal taxes when you flip a property for a profit. Each state has its own income tax law, and some have no income tax at all, so check with your state's revenue department to determine what the state tax implications of flipping homes might be.

When in doubt, ask for professional help

As you can probably guess, there's quite a bit of grey area here when it comes to the tax implication of a profit from flipping houses. For example, if you own a house and sell it within a year, is it considered a short-term capital gain (which means no self-employment tax) or ordinary income? And do you meet the IRS definition of a "real estate dealer" or are you a casual house flipper?

The point is that if there are any situations that aren't crystal clear, it's a smart idea to seek the advice of a tax attorney or other experienced professional who can advise on your specific situation as a real estate investor. IRS audits triggered by reporting a gain incorrectly are time-consuming and a big hassle, so it's well worth paying to get it right.

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