Introduction
Flipping houses can be a profitable venture, but before you dive in, you need to understand the tax implications—especially when using hard money loans. The IRS doesn’t treat all real estate transactions the same, and the way you buy, hold, and sell a property determines how much tax you owe.
Ignoring these tax consequences can eat into your profits and even put you at risk of penalties. So, let’s break down the seven key tax considerations you must know before flipping houses with hard money loans.
Complex Tax Laws Governing Real Estate Transactions
1. Capital Gains Tax: How Long You Hold Matters
When and for how long you retain ownership of a property before it is sold can make a huge difference in how your profits are taxed.
- Short-term capital gains (less than one year): Taxable as ordinary income, thus taxed at one’s appropriate income tax bracket.
- Long-term capital gains (more than one year): Eligible for preferential tax rates, as low as 0%, 15%, or 20%, based on the level of the taxpayer’s taxable income.
What This Means for You
Flippers should be prepared to accept that the tax on profits earned can’t really be sweetened if the property doesn’t sit for at least a year. If a reconceptualization of house flipping allows for keeping properties for more than a year, that would be a gigantic tax break indeed, but hold on before bestowing thanks on the house-flipping minority that actually relies on speed to turn profits.
2. Flipping Too Often? The IRS Might Call You a Dealer
The IRS classifies real estate investors differently based on their activity:
- Investor: Buys and sells properties occasionally and pays capital gains tax on profits.
- Dealer: Regularly flips houses, meaning profits are taxed as ordinary income and subject to self-employment taxes.
How Do You Know If You’re a Dealer?
The IRS looks at:
- Frequency of your flips
- Your intent when purchasing
- How much real estate contributes to your income
- Whether you actively market properties
If you’re classified as a dealer, you could face significantly higher taxes and lose the benefits of capital gains treatment.
3. Personal Liability When Using Hard Money Loans
Unlike conventional mortgages, many hard money loans require personal guarantees. That is, should your flip fail, the repayment responsibility falls on you (not just the property).
Risks of Hard Money Loans:
- High interest rates (often 10%-15%)
- Short repayment periods (usually 6-12 months)
- Fees and points that can add up quickly
How to Protect Yourself
- Use an LLC or business entity to limit personal liability
- Read loan terms carefully before signing
- Have multiple exit strategies in case the flip doesn’t go as planned
4. Self-Employment Tax on Flipping Profits
Flippers classified as dealers not only pay ordinary income tax at their individual tax rates but must also pay self-employment tax on their profits (15.3%). This is contributed to Social Security and Medicare.
How This Affects Your Profits
- If you flip houses several times a year, your taxes could exceed every tallied expense a traditional investor incurs.
- Self-employment earnings cannot be considered capital gains, thus are not eligible for lower tax rates.
- In order to avoid stiff IRS fines, you might also need to pay quarterly taxes.
Ways to Reduce Self-Employment Tax Include:
- Setting up an S-Corp or LLC and fit to be treated as an S-Corp.
- Satisfy the IRS with knowledge about tax-deductible expenses for all resources he/she has disbursed for business purposes in order to lower taxable income.
- Let the tax professionals assist in maximizing deductions.
5. Deductible Expenses to Lower Your Tax Bill
Flipping houses comes with a variety of expenses that you can deduct to reduce your taxable income:
Common Deductible Expenses:
- Interest on loans: Hard money interest is fully deductible.
- Renovation costs: The cost of materials, labor, getting city permits, and of course, contractors doing these works.
- Advertising: Photography, staging, and real estate broker commission.
- Closing costs: Title fees, attorney fees, and the cost of inspections.
Keeping good records of all expenses you’ve incurred just about assures the greatest tax benefits, which could lower overall taxes.
6. Timing Your Transactions Strategically
The timing of when you buy and sell a property can impact your taxes:
- Selling in less than a year? Expect higher short-term capital gains tax.
- Holding onto a property past January 1st? This could push the tax liability into the following year, giving you more time to plan.
- Planning multiple flips in one year? Consider spreading sales across different tax years to avoid moving into a higher tax bracket.
Being mindful of transaction timing can make a significant difference in your overall tax liability.
7. Tax Implications of Loan Origination Fees and Points
When working with a hard money lender for your flip loan, your lender might charge you some loan origination fee or points-a percentage of your loan amount. These fees will be treated for tax purposes in a way that could affect your profit.
How These Fees Impact Your Taxes
- Adds fees to property basis: Loan origination fees and points, in most cases, go into the basis of the property, capitalizing, and being deductible later rather than immediately. This would in essence increase the property’s basis that is subject to less tax when it gets sold.
- Amortization: In some cases, you may be able to amortize those fees into the life of the loan and finally start deducting from it.
Strategies to Manage These Costs
- Steady documentation: Make sound records of all loan expenses to correctly have it treated for tax purposes.
- Consult with a professional: Since everything may sound complicated, it is wise to work with a tax advisor to better inform you on how best to treat these fees.
Key takeaway
Real estate tax praxis can be a roller coaster dream, and minor mistakes may prompt audits or penalties; thus, here are some reminders:
- State taxes in addition to local taxes: A good instance is some states have their own taxes outside the federal control.
- Depreciation recapture: In the case where you were renting this unit for a while, the IRS might require you to bring some of this depreciation deduction back into the accounts when you sell.
- 1031 Exchanges: An alternative for property sellers that wish to defer tax by reapplying the proceeds from sale on the purchase of a similar property (not somewhere really applicable to flips yet worth considering for the long-term investors).
If you are still in doubt about tax dispositions, hiring real estate professionals within Munshi Capital can help guide you through the convoluted matters in hard money loan searches and the response to costly mistakes.
