Taxes involved when flipping property

[Marshall Secord]

Hi BP, I quit my full time job and closed on a property a couple months ago in Philly. I’m doing most of the renovations myself and I’m starting to sift through the potential taxes incurred once I sell. I’m a bit confused with what I’m reading about capital gains and self employment taxes. I was thinking I would be taxed on my profit in a similar percentage as my old w2 job was taxed, but now I’m scared that Uncle Sam is going to nail me for nearly half of my profits. Can anybody shed some light on this? 

[Kevin Romines]

Congrats on taking the leap of faith to get your investing career started. Analysis paralysis is a real thing for some people, so just the willingness to take action is huge for you. 

One of the problems you will encounter going forward is that without a W2 type income, you will have limited options for financing future purchases. 

Now on to the taxes. If you flip the property, meaning you didn't place the property in to service as a rental, you sold instead, you will be classified as a dealer by the IRS, your properties will be considered your inventory and you will be taxed on your profits at ordinary income rates (whatever tax bracket you are in that year) + 15.2% self employment tax. So if you are in a 22% tax bracket, you will pay 22% + 15.2% for a total of 37.2% of your profits, will be your taxes. in the worse case scenario, you could pay as high as 39% + 15.2% = 54.2% so in that case, Uncle Sam made more money on your flip than you did.

However if you place the property into service as a rental, and if that was your intent and you can prove that to the IRS, only then would you pay capital gains instead of ordinary income taxes + self employment taxes. If you held the property for less than 1 year but it was a rental during that time, you would pay short term capital gains tax of 20%. If you hold for more than 1 year as a rental, then you sold, you would pay short term capital gains taxes at 15%.

So your intent and your actions dictate if you will pay ordinary income + self employed, or if you will pay long term, or short term capital gains. If you hold as a rental for 1 year or more, you can then do a 1031 exchange which has the ability to defer your taxes, potentially all the way to your grave. 

I hope this helps?