Disclaimer: I am not a tax accountant, but I am a Real Estate Broker and Investor. If you want tax advice I would recommend consulting a CPA or tax professional.
If you were to watch HGTV or one of those other Reality TV shows about houses you will see the glamorized version of fix and flips. They make these shows over dramatized and oftentimes they over exaggerate the numbers. I have never once seen a show where they discuss the taxes involved with flipping houses, probably because taxes are not sexy and can’t be glamorized. If a property is purchased, rehabbed, and sold within 1 year the gains on that sale are taxes as ordinary income.
If you are an individual and you are flipping houses your profit from these deals are all taxed as ordinary income. Which on the federal tax side can be as high as 37%, you may also be subject to FICA tax(approximately another 15%) if you are labeled as a dealer by the IRS. This makes it very difficult to build wealth if you are giving up a majority of your earnings to the government.
A wise man once said “Debt and Taxes make the rich richer and the poor poorer”. What this means is if you can use debt and taxes wisely you will be able to build wealth quickly. If you spend all your earnings paying interest on debt and on taxes you won’t have much left to save and invest.
What if I were to tell you there are many tax advantages to renting the property and holding for over a year? The government incentives long term investors in many different ways. The 1st being if a property is held for a year and one day then that sale is taxed at capital gains rates instead of ordinary income. As of 2019 if you make below $38,600 per year you pay $0 in capital gains tax, if you make between $38,601-$425,800 then your capital gains rate is 15%, if you make $425,801 or over then your capital gains rate is 20%.
In addition to the better tax advantages on the sale of the property the government also allows you to depreciate the property for every year you own it if held as a rental. For residential Real Estate the government currently allows you to depreciate the building for 27.5 years. This means if you have a property you purchased for $120,000 and the land is worth $20,000 and the improvements(Building) are valued at $100,000 you can depreciate ~$3,636(100,000/27.5 years) per year. Depreciation is a non-cash expense that shelters your income. So if you made $5,000 in rental income you would only be taxed on $1,364($5000-$3,636) of income.
Oftentimes rental property owners who have mortgages on their properties end up showing a loss on their rental property due to depreciation. As they can expense the mortgage and other repair costs. So they show a loss on their taxes but end up cash positive due to depreciation sheltering some or all of their income. Now unfortunately depreciation is not free, you have to recapture the depreciation when you sell the property. The good news? The IRS gives you a break again and instead of paying ordinary income on the depreciation recapture you pay 25%. Tax law requires that recapture be calculated on depreciation that was “allowed or allowable,” according to Internal Revenue Code section 1250(b)(3), which means even if you don’t take depreciation when it is a rental property you are required to recapture it. See a tax professional for additional questions and specific advice.
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