Tax advantages: Flipping or Renting

[Nick Brubaker]

So, I have my first property under contract.  I'm excited about it because it offers good potential as either a flip or a rental.  In deciding between the two options I'm wondering:

Which strategy has more tax advantages, flipping (short term) or renting (long term)?

[Brandon Hall]

@Nick Brubakera strategy should not be determined based on the potential tax consequences except for rare cases in which a high net worth earner literally needs tax-free income. Tax strategies can certainly boost returns, regardless of what real estate strategy you employ, but I think asking "do the higher short-term returns make up for the tax consequences" is somewhat backwards. 

If you are really good at flipping but don't know how to value a rental's future stream of cash flows, then you should focus on flipping. If you've never flipped a home, but own rentals, then focus on the rentals. If you've never done either, figure out which method you'd enjoy and most aligns with your goals. 

Flipping is time intensive whereas owning rentals are not. Cash flowing $700 per month on a rental may not seem a lot to you until you realize you spend 30 minutes a month managing said rental. A $50,000 profit on a flip may seem like a lot to you until you realize you spent 1,000 hours on the project and the after-tax profits are roughly $25,000 thereby valuing your time at a post-tax $25 per hour (which isn't bad!). 

My point is that tax strategies should supplement your primary strategy but should not determine it. But I'll assume you already know that and entertain the question.

As @Chris Soignierhas correctly informed you, rentals offer the most tax benefits. You may operate your rentals in a way that qualify you to be "in business" which then allows you to deduct expenses similar to other business owners. Rentals generate passive income that avoids the pesky self-employment (SE) tax. Depreciation of the property also shelters a majority of the taxable rental income, if not all of it. There are also methods such as cost segregation to provide depreciation "boosts" in the early years of owning a rental, thereby guaranteeing tax free income for the first 5-10 years. On top of that, you can also focus on historical tax credits even further putting you into the black.

Flips, on the other hand, generate earned income subject to SE tax. SE tax is a full 15.3% on 92.35% of your profits. Those profits are then subject to your marginal tax rate meaning that the total tax on your flipping profits can be substantial. They cannot be covered by depreciation, historical tax credits, etc as these profits are not considered to be passive income. 

Flippers achieving $40k profits should look into utilizing an S-Corporation. Doing so will provide substantial tax benefits as new tax planning opportunities will present themselves. 

Regardless of what method you choose, the two questions you should answer are: (1) which strategy would I enjoy doing more? and (2) which strategy will allow me to scale?