Flipping houses, capital asset or business operations

However, there is still a lot of confusion around taxes and flipping houses for profit. In many cases, real estate is considered a capital asset, and the sale of the home can qualify for preferential capital gain tax rates. However, when you’re in the trade or business of flipping houses for profit this may not be the case.

Normally, if you purchase a piece of real estate to fix up and sell it at later date, the profit is taxed under the capital gains rules. However, the IRS classifies individuals who actively purchase and remodel real estate for profit on a continuing basis as dealers rather than investors. For these people, the real estate is treated as inventory, rather than capital assets, and the profits on the sale of those properties is treated as ordinary income, subject to the self-employment tax.

Another source of confusion is that many potential flippers believe they can avoid taxation if they roll the proceeds of the sale into purchasing another project to flip (i.e., the property ladder theory). The truth is, if you’re considered to be in the trade or business of flipping real estate, this is not possible, as this treatment isn’t allowed for property held for resale.

House flipping is obviously a costly business, with numerous expenses incurred along the way. Most of these expenses are not immediately deductible. Instead, they must be capitalized into (i.e. added to) the basis (the original value) of the residence. Capitalized costs include:

• The cost of the home itself
• Direct materials
• Direct labor
• Utilities
• Rent
• Indirect labor
• Equipment depreciation
• Insurance
• Production period interest
• Real estate taxes allocable to each project

You then get a tax benefit from these expenses when you sell the property as the taxable gain is reduced by the amount of basis in property.