Selling a House
1031 Exchange Rules Explained
Looking for a way to defer capital gains tax when selling your investment properties? We look at 1031 exchange rules, which might just be..
What Taxes Should I Worry About When Flipping Houses?
The taxes on flipping houses can easily catch you off gaurd. Make sure you are prepared and have a strategic plan in place before starting to flip a house.
Madison Clifton
Aug 1, 2019
Flipping houses is a great investment opportunity regardless if you are actively or passively participating in the investment. The taxes on flipping houses at the end of the process can easily take you by surprise though. Get an overview of what you can expect so you are not caught off guard by the high costs. There are many different factors that contribute to what the taxes on your investment will be, so be informed about the specifics of your situation. If you are prepared you can take the necessary steps ahead of time to potentially save some money on taxes, and come out with a significant profit.
Short Term Capital Gains vs. Long Term Capital Gains
When you own an investment, whether it is a house, stocks or anything else, for less than a year and sell it for a profit, it is considered short term capital gain. Short term capital gains are taxed at your ordinary income tax rate. If you own a property for more than a year, it is considered to be a long term capital gain. Long term capital gains are taxed at a much lower rate than short term capital gains.
Long term capital gains tax is between 0% and 20%, with people in the middle class paying around 15%. Short term capital gains tax is between 10% and 37%. What you pay on your short term capital gains is entirely dependent on your current tax bracket. Regardless of your tax bracket, it is likely that you will pay significantly more in taxes on your investment if it classified as a short term capital gain.
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FICA Taxes
FICA taxes are social security, medicare, and medicaid taxes. If you are working a 9 to 5 day job, then 7.65% is being taken out for these taxes every paycheck. Your employer pays another 7.65% on your behalf. Making the total owed for FICA taxes 15.3%. Anyone classified as self-employed or in business for themselves, which most house flippers are even if they have a day job as well, must take the hit of paying the full 15.3% themselves. Bringing the potential total in taxes for a short term gain between 25.3% and 52.3%.
Luckily, if you only flip one or maybe two houses a year you may be able to avoid the classification of being “in business.” You will still be required to pay your ordinary income tax rate on a short term gain, but it is possible you could avoid the double FICA tax. This is in a legal grey area and it is best to have the conversation about avoiding the full taxation with your accountant.
FICA taxes are only subject to short term capital gains. Therefore, if you investment qualifies as a long term capital gain, you will not be subject to any FICA taxes.
State and Local Taxes
Your state and local governments also have income taxes that you must pay on an investment you made a profit on. Every state and local government with have different tax rates. As well as different rules and regulations on how income tax is handled. But, for example, say you live in Salt Lake City, Utah. The income tax rate for Salt Lake City is 5%, and the income tax for Utah is 4.95%. Therefore, in total you would pay 9.95% in state and local taxes.
Most states charge do not differentiate between long term and short term capital gains when it comes to collecting taxes. So, this tax rate can be expected for both long term gains and short term gains.
How Taxes Are Calculated
Say you are unmarried living in Salt Lake City, and have an annual income of $70,000. This puts you at 22% income tax rate at the federal level. As well as paying 9.95% in state and local income taxes.
Taxes are taken out of your final profit. Profit = Sales Price – Total Expenses. Let’s say you purchased a house to flip for $50,000 and expenses after that totaled to $40,000. You then sold the property for $115,000. After adding your purchase price to your expenses, to get your total expenses, you then subtract that from the selling price to get your profit. (115,000 – 90,000 = 25,000)
Federal Tax = $5,500 (22%)
FICA Taxes = $3,825 (15.3%)
State and Local Taxes = $2,487.50 (9.95%)
You would pay $11,812.50 in taxes, making your net income (25,000 – 11,812.50) $13,187.50.
Remember that because you are self-employed you must pay estimated quarterly income taxes. If you fail to pay a sufficient amount in estimated quarterly income taxes, you will be penalized by the IRS when you file your income taxes the following April.
How To Save Money
Now that you have gotten a picture of how much the taxes on flipping houses can be, you are probably interested to know how you can save some money.
Maximize Deductions. Maximizing your deductions really only costs you your time. It should be something that every investor is doing to maximize their profits. There are many real estate investment tax deductions. Many expenses associated with actually renovating the home can be deductible, such as labor, and material expenses. There are less obvious deductions as well though. Since you are technically self-employed, your home office, part of your rent, utilities, and vehicle expenses can be deductible as well.
Hold the Property for Over 1 Year. You have probably already guessed this is a good way to save money. The taxes that are involved with short term gains are extensive and become very expensive. On the example above, if it was calculated as a long term gain the total you would pay in taxes would be close to $6,240. That saves you about $5,572 in taxes. As stated earlier, the long term capital gains tax is only around 15% for many individuals, and FICA taxes are not paid on long term capital gains. In the end, this method saves you a significant amount of money and is an option worth considering.
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Paying Your Taxes
Make sure you do your research beforehand about the taxes on flipping houses that you specifically will have to pay, and know your options. This would be a good time to review the rules of a 1031 exchange. Every situation is a little different, so you want to be as prepared as possible before you begin flipping a house.
No one likes paying their taxes, and the amount taken out of your profits at the end of the day can be discouraging. If you have a strong investment though, and are willing to be strategic and flexible in your plan for that investment, you have the ability to make a significant profit.