Are The Properties That We Flip Subject to Self-Employment Taxes?

[Aaron Laster]

Disclaimer: I am not a tax professional, and you should talk to yours about the tax strategies that would work best for your situation.

Flipping properties has been one of the most popular ways to profit from real estate investing. Although flipping properties is a popular strategy, most investors do not realize that unless your flip meets requirements, set by the IRS, it could be subject to self-employment tax (an additional 15+ percent of your profit). At this point, you may be asking, “Well how can I avoid paying self-employment tax and keep all of my profit?” Below I will explain one of the ways that has worked for many real estate investors.

What is your intent with this property?

Is it your intention to rehab the property to flip or rehab to rent out? How would the evidence of your real estate transactions support your intent? The difference can have a major impact on the amount of taxes that you are subject to pay.

In real estate, you can either be an active investor or a passive investor. The IRS looks at active investors more like a retailer than an investor, like a landlord.

If after talking with your tax professional, they determine the evidence shows your investment will be considered a flip, then I would suggest electing your LLC to be treated as an S Corp (IRS Form 2553). When your entity is elected to be treated as an S Corp, you can split your income. You are able to split the income by paying yourself a "reasonable salary" and a "distribution/dividend". Unfortunately, your salary will be taxed as ordinary income and you'll pay self-employment tax on that portion. But, the distribution will not be subject to this tax.

In my opinion, the best option when it comes to flipping is to buy at a substantial discount, fix the property, rent it for a while to collect some passive income, and sell it as a turnkey rental to another investor. This strategy shows that your intent for this property is to be a landlord. There is a solid chance that the self-employment tax will be removed, of course after considering all other evidence of your intent with the property.

A flipper vs. a landlord flipping a rental from their portfolio of rentals

Below I will give a few examples to support my points from above.

Let’s say Mary Jane has been flipping houses for 20 years and would consider this her full-time job/primary source of income. She regularly buys properties, fixes them up, and sells them months later for a profit, but never rents these properties. She’s had an entity for her flipping business from the beginning and has been taxed like a partnership since she has never elected to be taxed as an S Corp. Mary Jane is a good example of someone whose business practices would point to the investor's income from these investments being taxed like a flipper, self-employment tax included.

The best strategy for Mary Jane is to elect to be taxed as an S Corp so that she can split her income into a reasonable salary and a distribution/dividend. This doesn’t get her out of paying self-employment tax altogether, but it does get her out of paying it on the distribution income.

Example: If MJ made $100,000 after buying, rehabbing, and selling the property, she would split that income into a salary and a distribution. Let’s say a reasonable salary is $30,000 for this property, and she’s held it for less than a year. MJ will save $10,710 in taxes by splitting her income. How? Out of her $100,000 of income, $70,000 will be a distribution and will not be subject to the additional self-employment tax, and $30,000 will be her salary. Here is how I calculated her tax savings by using this strategy (70,000 x 15.3% = $10,710).

Michael, on the other hand, invests in real estate of various kinds, whether it’s flipping, renting small multifamily, property management, wholesaling, etc. He recently purchased an old house in a community that is seeing a lot of revitalization. He is not sure if he should sell the house after he fixes it up or rent it out. He reaches out to his tax professional to see if there are differences in taxation. His tax professional helps him understand the implications of his decision and gives him guidelines to follow to ensure the lowest amount of taxes are paid on his income when he sells the property.

Example: Michael, like Mary Jane, made $100,000 from the sale of a similar property. Instead of part of his income being subject to self-employment tax, he’ll be able to save $15,300… How in the world is Michael able to do that? I’m glad you asked! His savings can be calculated using the same simple formula (100,000 x 15.3% = $15,300). Not that it is a competition but as a passive investor, Michael doesn’t pay self-employment tax meaning he will be able to save $4,590 more than Mary Jane.

As a real estate investor, you have options and I am nowhere close to covering all of them in this short article. Depending on your investment strategy and intent, you can be flexible in what strategy you choose to reduce your taxes. I suggest getting a smart tax professional on your team to figure out the best strategy for you while still doing your own research. Many think that tax professionals are expensive but you pay for what you receive. I made the mistake of trying to do my complicated taxes on my own a few years back and will never make that mistake again! Perfect planning prevents poor performance (in this case, financial performance).

I hope this article inspires someone to get out and take action because it's never too late to invest in real estate! If you have any questions or comments feel free to respond to this post or shoot me a direct message.