Taxes and flipping houses as a business
Flipping houses as a business has significant tax implications.
Following the 2008 housing crisis, house flipping became a boon to real estate developers and brought a great deal of public fascination. Popular shows are numerous, such as Flip or Flop and Property Brothers on HGTV, documenting the ins and outs of this niche industry. In fact, Nielsen found that the HGTV was the fourth most watched cable network in the United States in 2018. Currently, house flipping is at a 12-year high. Out of all homes sold annually in the United States, those sold by house flippers account for 7.2% of all sales.
The allure of unique challenges and payoffs surround the industry and captures public attention. However, the tax implications of flipping houses can be significant and those who are inspired to pick up a hammer should be aware before buying their first flip-worthy home.
Homeowners with a DIY itch can flip their own house
Owning a home in the United States is one of the most important investments a person can make. Not only is a home one of the largest assets that the average American family owns, it also could be considered one of the primary sources of accruing wealth. The importance of home ownership in the United States is an integral part of the economy and it is prioritized in the tax code.
A taxpayer with an itch to flip homes should consider flipping their own home instead of purchasing and flipping other people’s homes. Tax deductions for personal property taxes and home mortgage interest can help homeowners with the costs of home ownership. Like investors, after owning a home for longer than one year, the gains on the sale are treated as capital gains and taxed at a maximum rate of 20% (rather than the usual 37%).
However, the most important tax benefit for the homeowner is the §121 sale of home exclusion. This provides an exclusion of $250,000 ($500,000 for certain joint filers) of the taxable gains on the sale of the taxpayer’s primary residence. For the home to be considered a primary residence, the home must be owned and used by the taxpayer as their primary residence for two of the last five years looking back from the date of the sale. Further, the taxpayer also cannot claim the sale of home exclusion during the two years leading up to the date of the sale.
For example, Albert purchased a home for $300,000. Albert uses the home as his primary residence for 3 years. Then, Albert decides to sell the home for $400,000. Albert has a capital gain of $100,000 ($400,000 minus $300,000). Albert can use the exclusion to exclude the capital gain of $100,000. Thus, nothing is taxable on the sale of Albert’s home.
If the taxpayer owns and uses the home as their primary residence for two of the last five years from the date of the sale and has not used the exclusion within the last two years from the date of the sale, the taxpayer qualifies for the sale of home exclusion. The exclusion is not affected by the fact that the taxpayer had spent a great amount of time and effort improving the house’s value. Further, taxpayers can use the exclusion multiple times throughout their lifetime as there is no limit. Thus, as long as the taxpayer meets the sale of home exclusion requirements, the taxpayer would be able to exclude $250,000 of capital gain on the sale of a home that they “flipped.”
These tax rules for house flipping provide advantages to homeowners and incentivize them to improve their homes to generate tax-free wealth.
Getting into the business of house flipping has significant tax implications
Tax rules for house flipping classify taxpayers in the business of flipping homes as “dealers” in real estate. When a taxpayer decides to go into house flipping as a business or even a side business, the house itself is not treated as a capital asset for tax purposes. That means the homes purchased for flipping are treated as inventory of the taxpayer instead of capital gain property. Thus, when the taxpayer sells the property for a gain, the special capital gain tax rates won’t apply to the sale. Instead, they must pay ordinary income tax rates on the sale of the property. For example, sole proprietors in the business of house flipping would report the sale of the house on Schedule C (Form 1040) instead of Schedule D (Form 1040).
Further, no automatic tax deduction for expenses and costs of the house-flipping is allowed for dealers because they must capitalize all direct materials, direct labor, and indirect costs allocable to each job or house. Indirect costs include utilities, rent, indirect labor, equipment depreciation, insurance, production period interest, and real estate taxes. These costs aren’t recognized by the dealer on their tax return until that property sells. Thus, house flippers who are dealers could incur all of these costs in one year but aren't able to write off those costs until the year the property is sold.
Investor status means capital gain treatment and deduction of certain expenses
A taxpayer who purchases a house for its future, appreciated value instead of buying a home to flip, treats the house as an investment property and is an “investor” rather than a dealer. One benefit for investors is that an investment property held for longer than one year is taxed at the preferential capital gain rates instead of ordinary income rates. Further, investors can deduct real property taxes and mortgage interest paid for an investment home on Schedule A (Form 1040) in the year it was paid. However, the TCJA limits the amount of deductible real property taxes to $10,000.
While investors can deduct real estate taxes and mortgage interest, they cannot deduct other expenses associated with investment houses for years 2018-2025. The TCJA suspends the miscellaneous itemized deduction for investment expenses until 2026. These expenses include items such as attorney or accounting fees, utilities, or insurance.
Even without the deduction for investment expenses, an investor in houses still enjoys a greater tax benefit than those who are dealers in houses (i.e. house flippers) due to the capital gain tax treatment of the income. Thus, those who are thinking of dabbling in the real estate market but are not handy with power tools, may consider becoming an investor instead of a dealer in real estate.
Considerations for deciding if dealer or investor status is more beneficial
Investors and dealers can have very different tax situations. Some things to keep in mind include:
- The QBI deduction doesn’t include capital gains in the calculation. So, dealers might have a tax benefit from claiming the QBI deduction regardless of the lower capital gain tax rate.
- The $10,000 SALT limitation prevents investors from deducting more than $10,000 in property taxes each year.
- The holding period rules do not affect the taxpayer’s overall tax rate which could be lower if the taxpayer is a dealer that is also a corporation, for example.
- Dealers can deduct more expenses because investors are limited to deductions on Schedule A (Form 1040).
The investor or dealer distinction makes a difference for capital gain treatment
Whether a taxpayer is an investor in homes instead of a dealer of homes has significant tax implications for house flippers, as previously discussed. To determine if a person is considered a real estate dealer instead of an investor, first look to whether the homes are held for sale to customers in the ordinary course of business based on the facts and circumstances of the taxpayer’s particular situation. Among the factors to consider are:
- Owner’s intent (nature and purpose for which the property is acquired);
- Extent of improvements and advertising to increase sales;
- Number, frequency, and substantiality of sales;
- Duration of ownership;
- Continuity of activity related to sales over a period of time;
- Extent and nature of the efforts to sell the property;
- Extent of subdividing and development to increase sales;
- Use of a business office for the sale of the property; and
- Character and degree of supervision or control over representatives selling the property.
For example, taxpayers who decide to try their luck at house flipping and flip a single home for resale would likely be considered a dealer instead of an investor. Only flipping one house would usually favor investor treatment, however, the taxpayer’s intent was to flip the house for resale and make improvements to the property to increase its value are both factors that swing toward dealer classification rather than investor.
For example, the Tax Court found that a full-time American Airlines pilot who built one house as a side project was project was a dealer instead of an investor, even though it was the only house that the pilot had ever attempted to sell, the pilot was still treated as a dealer because his intent was to form a business and make improvements (in this case, build a home) for an increased sale price.
It’s clear that the tax implications of house flipping are varied, and the most beneficial tax situation depends on the individual and their DIY dreams. Taxpayers who aren’t sure how their activities will be classified should review the rules and set up an appointment with one of our experts for help.
 Ralph S. Norris, TC Memo 1986-151.