House flipping is a term that typically refers to the practice of buying and quickly reselling homes for profit. In many cases, the flipper purchases a residence that needs work, makes the necessary upgrades and repairs, and then sells the property for more than they invested. According to ATTOM Data (a provider of nationwide property data), the average profit for a house flip in 2022 was $70,000. That’s a tidy profit for what is often a short-term project.
However, that profit is a capital gain and usually a short-term gain. That means the yield is subject to a levy at the same rate as the rest of your ordinary income—which could be as high as 37 percent. On the other hand, if the flipper owns the house for more than a year, the gain is typically considered long-term, and the rate is imposed at the lower rate, which tops out at 20 percent. Still, most flips are completed in less than a year; either way, the tax takes a chunk out of the gain.
How can house flippers minimize or avoid taxes?
Some house flipping advisors may tell potential investors that they can defer the recognition of the capital gains (and the tax) by reinvesting the proceeds using a 1031 exchange. However, this approach is risky since flipping typically doesn’t satisfy the IRS requirements for a 1031 exchange. A flip involves property being held for resale, which does not qualify. Instead, property eligible for a 1031 exchange must be held for investment or used as a business. For example, if you own residential property that you rent out to earn income, that is likely to qualify for a 1031 exchange. Similarly, you can use the approach to reinvest proceeds from selling other commercial property.
As with other real estate investments, taxpayers can deduct expenses from income. In this case, you can deduct the cost of acquiring, improving, and selling the property from the proceeds.
Consider a QOZ investment.
Whether the capital gain is short- or long-term, the investor may be able to defer the capital gains taxes by investing the proceeds in a QOZ project. While some of the original incentives for QOZ investments have expired, there are two potential advantages to investing capital gains into a QOZ. Both of these should be evaluated as a bonus when considering an investment that already makes sense. In other words, the tax advantages may not be adequate to overcome the potential risks of a questionable project, so always ensure that the investment aligns with your risk strategy.
- Deferral of taxes. If you invest gains into a QOZ project, you can defer the taxes on that gain until either December 31, 2026, or until you sell the asset, whichever comes first.
- Exclusion of additional gains within the project. This provision means that if you reinvest capital gains into a QOZ fund and leave it there for at least ten years, you will not owe taxes on the gains you earn from the investment. You will still owe the tax on the original amount you invested (deferred until 2027) but not on the profits accruing from the reinvestment.
For example, if you earn $70,000 from flipping a house and you then reinvest it into a QOZ fund this year (within 180 days of receiving the funds), you can defer payment of taxes on that $70,000 until after December 2026. In addition, any profit from the reinvested $70,000 will be free from capital gains taxes if you hold the investment until 2033.
Flipping houses is potentially profitable, but there are pitfalls, including the taxes that may be assessed on any profit.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
FAQs
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
What is a simple trick for avoiding capital gains tax? ›
An easy and impactful way to reduce your capital gains taxes is to use tax-advantaged accounts. Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don't pay income or capital gains taxes at all on the assets in the account.
How do house flippers file taxes? ›
Where to report in the tax return. A taxpayer who is a sole proprietor and whose business is buying and selling homes should report that activity on Schedule C. The homes they purchase, improve, and offer for sale will be their inventory.
How to avoid paying capital gains tax on inherited property? ›
Here are five ways to avoid paying capital gains tax on inherited property.
- Sell the inherited property quickly. ...
- Make the inherited property your primary residence. ...
- Rent the inherited property. ...
- Disclaim the inherited property. ...
- Deduct selling expenses from capital gains.
When does capital gains tax not apply? If you have lived in a home as your primary residence for two out of the five years preceding the home's sale, the IRS lets you exempt $250,000 in profit, or $500,000 if married and filing jointly, from capital gains taxes.
How do rich people avoid capital gains? ›
Billionaires (usually) don't sell valuable stock. So how do they afford the daily expenses of life, whether it's a new pleasure boat or a social media company? They borrow against their stock. This revolving door of credit allows them to buy what they want without incurring a capital gains tax.
How do I get zero capital gains tax? ›
Capital gains tax rates
A capital gains rate of 0% applies if your taxable income is less than or equal to: $44,625 for single and married filing separately; $89,250 for married filing jointly and qualifying surviving spouse; and.
At what age do you not pay capital gains? ›
Capital Gains Tax for People Over 65. For individuals over 65, capital gains tax applies at 0% for long-term gains on assets held over a year and 15% for short-term gains under a year. Despite age, the IRS determines tax based on asset sale profits, with no special breaks for those 65 and older.
What is the house Flipper 70% rule? ›
The 70% rule helps home flippers determine the maximum price they should pay for an investment property. Basically, they should spend no more than 70% of the home's after-repair value minus the costs of renovating the property.
How much profit do house flippers usually make? ›
The best market by profit is San Jose/Sunnyvale/Santa Clara in California, where flippers made an average of $275,250 in 2023. The worst market for house flipping is Austin/Round Rock, Texas, which is the only market in which flippers lost money in 2023. The average ROI was -4.1%, and losses averaged out to $18,640.
Generally, the profit from house flipping is taxed as ordinary income and is subject to self-employment tax if the house flip is done by an individual. Frequent house flippers can reduce their self-employment tax liability by purchasing the houses through an LLC or S-corp.
What is the lifetime capital gains exemption? ›
When you make a profit from selling a small business, a farm property or a fishing property, the lifetime capital gains exemption (LCGE) could spare you from paying taxes on all or part of the profit you've earned.
Do I have to pay capital gains if I inherit my parents' house? ›
You do not automatically pay taxes on any property that you inherit. If you sell, you owe capital gains taxes only on any gains that the asset made since you inherited it. You may want to talk to a professional advisor to make sure you plan your finances out correctly with the capital gains tax in mind.
How to avoid capital gains tax on a house? ›
You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion. In addition, the 1031 like-kind exchange allows investors to defer taxes when they reinvest the proceeds from the sale of an investment property into another investment property.
Is there a way to avoid capital gains tax on the selling of a house? ›
Home sales can be tax free as long as the condition of the sale meets certain criteria: The seller must have owned the home and used it as their principal residence for two out of the last five years (up to the date of closing). The two years do not have to be consecutive to qualify.
Do I have to buy another house to avoid capital gains? ›
You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion. In addition, the 1031 like-kind exchange allows investors to defer taxes when they reinvest the proceeds from the sale of an investment property into another investment property.
Where should I put money to avoid capital gains tax? ›
Investing in retirement accounts eliminates capital gains taxes on your portfolio. You can buy and sell stocks, bonds and other assets without triggering capital gains taxes. Withdrawals from Traditional IRA, 401(k) and similar accounts may lead to ordinary income taxes.
What is the 70 rule in flipping houses? ›
The 70% rule helps home flippers determine the maximum price they should pay for an investment property. Basically, they should spend no more than 70% of the home's after-repair value minus the costs of renovating the property.
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