In my opinion, most real estate investors don’t understand the tax implications of their investing. I was very fortunate to have Tarek El Moussa write a guest post on the tax implications of flipping houses.
When you own your own real estate business it’s important that you treat it like a real business from the get-go – and not a hobby. Part of starting your own business means of course that you’re not going to be taking home a W-2 and filing taxes online like people with a regular 9-to-5 job. That’s where having a great accountant who has experience working with real estate investors is essential to ensure you can claim the most legally allowed deductions and receive the most tax benefits from your properties.
When we started looking for a good accountant to manage our house flipping finances we were shocked at how few of them knew anything about real estate investing. Just because someone is a CPA doesn’t mean that they have any experience or knowledge of the tax breaks that are available to you as a real estate investor. Buying and selling property is governed by a unique and complex set of rules and regulations. It’s essential that not only your accountant has a solid knowledge of these regulations, but that you also understand what you can and can’t do – and what kind of actions trigger taxable events. While I’m no tax expert, here are some of the basics that you need to know about when running a fix and flip business:
Flipping Is Considered Active Income
First of all, while Christina and I consider our flipping business as a great lifestyle choice and we don’t have to fight the traffic and drive into the office every morning, our income from our flips isn’t considered passive income. That means it’s subject to different tax rules than passive income from rental properties or the income from long-term property sales and exchanges for held properties. This is an important distinction for you to understand (and for your tax accountant to have an in-depth knowledge in – because if they wrongly classify your flipping income it could cause a lot of headaches, trouble and stress from the IRS down the line).
1031 Exchanges Don’t Apply
You’ve likely heard about 1031 exchanges, or perhaps even seen a real estate ad mentioning the house was being sold as a 1031 exchange, but what does this actually mean?
If you sell a rental property that you had been holding and then buy another investment property within a certain amount of time, you can defer your capital gains tax with what’s known as a 1031 exchange until you sell that property. Then you can do another exchange and continue to defer that tax almost indefinitely (deferring that tax means you don’t have to pay it for a certain time frame so instead of handing over a check to the IRS, you can put that “tax money” to work for you instead until you do have to pay it.)
However, here’s the rub. You can’t apply 1031 exchanges to flip properties. So, if you’ve been holding an investment property for a while and want to sell it to invest in another one, you need to make sure that the new property is subject to 1031 exchange benefits so that you don’t end up owing the capital gains tax on the property and diminishing your investment. But it Gets Even Trickier. There’s No Strict Tax Definition for Flipping And that’s where it gets really interesting. You can make a living with your real estate business flipping houses, but that doesn’t mean that every property you buy is automatically considered a fix and flip. If you choose to invest in some fix and hold properties, you can use them as a shield against capital gains tax. Plus, the rules on what is and isn’t a flip can get really interesting, too. If you buy a house and rehab it with the intention of holding and renting it, but then you get a great offer out of the blue from a buyer, guess what? The IRS actually doesn’t consider that sale a flip. Weird, right? Also, there is actually no capital gains activity at all on flip houses. That means that you don’t owe extra taxes on each property that you flip when you sell it. Instead, because this is considered active income by the IRS, you’re subject to either payroll or self-employment taxes. In other words, you’ll need to put yourself on the payroll, take taxes out of your paychecks, and give yourself a W-2…or you can basically act as a 1099 employee for your real estate business. Honestly, when it comes down to the details of payroll and when to take taxes out of your income, talk to your accountant. This is a complex area that makes my head spin so I’m not even going to try and explain it to you. They will do a much better job and they can help you understand what you owe and when you owe it, and they can help you deduct as much as possible so that you still get a tax refund each year (or at least so that you don’t have to cut huge checks for the IRS every year). So those are the basics of how you can stay in good standing with the IRS as you build your real estate business with fix and flip and/or fix and hold houses. Remember, the information I’ve outlined above doesn’t even begin to scratch the surface about tax issues for your flipping business, but it’s a good start. Use the information I’ve outlined to interview prospective tax accountants to see if they know their stuff. And if they can’t talk to you about each of these topics in a lot more detail and a lot more knowledgeably than I have – then run, don’t walk out of their office! Having a great tax accountant on your team is essential to your success and getting the most out of your investments!
Tarek El Moussa is the co-star of HGTV’s most popular real estate reality tv show Flip or Flop along with his wife Christina El Moussa. The couple started Success Path Education and teach students from all over the country how to successfully invest in real estate.