IN THIS CHAPTER

check Calculating the tax man’s cut

check Maximizing your tax savings on a primary residence’s sale

check Discovering what you can deduct on your income-tax return

check Deferring taxes and selling property at a loss

check Handling taxes when you flip full time

You start flipping houses with the confident presumption that you’re finally working for yourself. Instead of kowtowing to an overbearing supervisor and trading the best years of your life for a skimpy paycheck, you get to be your own boss and pocket the entire profit from your labors.

After you flip your first house, however, you may start to feel like you’re working for the government. If you’re doing quick flips, holding properties for only a year or less, your profits are subject to short-term capital-gains taxes up to a whopping 43.4 percent!

Evading taxes is always a choice, assuming you don’t mind bunking with your fellow inmates at a federal prison, but I’m not about to recommend tax evasion as a viable alternative. Instead, in this chapter, I show you how to take advantage of legal tax exemptions and deductions and structure your deals to pay as little tax as required by law.

Shameless disclaimer: I’m no CPA, accountant, or tax attorney, so I’m not providing advice in this chapter. Besides, tax laws are constantly changing, and state and local taxes vary depending on where you live, so even if I could offer you some sage advice, I couldn’t possibly guarantee that it would be accurate for you and where you live. The information I offer in this chapter merely provides you with a stepping-off point that can help you communicate more effectively with your CPA or tax specialist. See Chapter 4 for information on finding an accountant to add to your flipping team. For general tax information and forms, visit the Internal Revenue Service (IRS) website at www.irs.gov.

Estimating the Tax Man’s Take from Your Flipping Profits

You can get yourself into a real tax jam when flipping properties if you don’t know upfront how the IRS and your state and local taxing authorities classify your profits. If you go in thinking that the most you have to pay is 15 percent in capital-gains tax, you may find an unpleasant surprise in your mailbox when tax time rolls around.

To avoid any future shock, know the tax man’s cut upfront and how your house flipping strategy affects the percentage you pay in taxes:

You owe 0 percent if you flip a home in which you lived for two of the past five years. See the later section “Maximizing Tax Savings from the Sale of Your Principal Residence” for details.
You owe anywhere from 0 to 23.8 percent of your net profit in long-term capital gains if you hold the property for at least a year and one day.
The tax rate for capital gains varies depending on the income-tax bracket you fall into based on your ordinary income (from your day job). For the two highest tax brackets, the short-term and long-term rates include a 3.8 percent Medicare surcharge.
You owe the same percentage in tax on your net profit as you do on your ordinary income (from your day job) if you hold the property for one year or less.
You owe standard income tax if you flip houses for a living. When profits from flipping houses are your sole income, the IRS may consider flipping to be your job and tax your profits as income, complete with an additional 15 percent in self-employment tax. (See “Paying Income Tax: When Flipping Houses Becomes Your Occupation,” later in this chapter, for details.)

Table 23-1 compares the tax rates for ordinary income and short- and long-term capital gains. Your tax rate varies according to your total income (not shown in the table), but you can see from the table that if the profit from your flip qualifies to be taxed as a long-term capital gain, it will be taxed at a significantly lower rate than if it qualifies as ordinary income or a short-term capital gain.

TABLE 23-1 Short-Term versus Long-Term Capital-Gains Tax Rates for 2016

Ordinary Income-Tax Rate (%)	Short-Term Capital-Gain Rate (%)	Long-Term Capital-Gain Rate (%)
10	10	0
15	15	0
25	25	15
28	28	15
33	33	15
35	35	15
39.6	39.6	20

Never postpone a sale in the hopes of improving your tax position. Take the sale when you have the sale. If the buyer backs out because of your delay, you stand to lose a lot more than you stand to save on taxes.

Maximizing Tax Savings from the Sale of Your Principal Residence

Living in the house you flip provides you with much more than a roof over your head. It qualifies you for a whopper of a tax exclusion. If you’re married and you sell the house you’ve lived in during the past two years for a profit of $500,000 or less, you can stuff the money in your pockets and purse tax-free, at least according to the tax rules in place when I was writing this book. If you’re single or married filing separately, you can deduct only $250,000, a comparatively paltry sum, but better than nothing.

Here’s how it works: The profit from the sale of a house you own for more than 12 months is subject to a 15 percent capital-gains tax plus any additional taxes that your state or local taxing authorities lump on top. If you and your spouse live in the home for at least two years, however, the IRS excludes the first $500,000 of the proceeds ($250,000 if you’re single) from capital-gains tax. Any amount over that is subject to tax.

To take advantage of this exclusion, your home must be your principal residence, you have to own it (duh!), and you must have lived in it for two of the past five years. The following sections help you determine whether you qualify for this most generous tax break.

Consider buying two houses. Pick the one that promises the most profit and takes the longest to rehab as your principal residence, and plan on spending at least two years fixing it up. While you’re taking your time slowly renovating that property, do a quick flip on the other property. When you’re done flipping that one, do a quick flip on another property. Following this approach, you can take advantage of the tax exclusion on your most profitable property (the long-term flip) while generating income with lower-profit, shorter-term flips.

KNOWING THE TAX RULES BEFORE YOU FLIP

A woman I know flipped her first house — a shabby two-bedroom job that she purchased for $120,000, renovated to the tune of $20,000, and sold for $175,000, walking away with a cool $35,000 in profit. And it took her only a little more than ten months. She was ecstatic! But when she visited her accountant to tell her the great news, ecstasy quickly turned to agony.

The woman’s accountant informed her that because she had owned the home for less than a year, her profit qualified as a short-term capital gain, taxable at the rate of 35 percent (at the time), which cost her $12,250 in federal taxes alone. If she had held the home for an additional two months, the profit would have qualified as a long-term capital gain taxed at the much lower rate of 15 percent, and she could have saved $7,000!

As I say in the section “Estimating the Tax Man’s Take from Your Flipping Profits,” earlier in this chapter, you should never postpone a sale in order to take advantage of a tax break. The woman may have held onto her house for two more months only to find out that buyers were no longer interested in it, and she could have lost more money by having to sell the property for less. However, this particular seller could have saved taxes by leasing the property to the new buyers until after the one year was up and then closing at that time. Know the tax laws so you can establish a well-informed plan and avoid surprises that may lead to unnecessary regret.

Proving “principal residence”

Government officials like to quibble about the meanings of words. To close any loopholes in the tax law that applies to using your home as your principal residence, they carefully define the term “principal residence.” For your home to qualify as your principal residence, you must

Live in the home instead of rooming with friends or renting from relatives.
Have your mail and utility bills delivered to this address.
File your homestead exemption for this property with your county and state.
Use this address on your driver’s license, voter registration, tax returns, car registration, and so forth.
Bank and shop in the vicinity of your home. No, the government doesn’t really care where you bank or shop, but in close calls, the auditor may want to see grocery receipts that prove you live in the neighborhood.

A good rule of thumb for determining the location of your principal residence is this: If your mom’s coming to visit you, which house does she come to?

Qualifying for the two-out-of-five-years rule

The two-out-of-five-years requirement is fairly straightforward — over the course of five years, you have to use the house as your principal residence for at least two years. If you spend a year island-hopping in the Caribbean, that year doesn’t count, but a year in which you’re away on vacation for six weeks counts as a full year. Check with your accountant or tax specialist to determine the exact amount of time you can be away from your home and still qualify as having lived there for a full year.

You can claim the exclusion only once in any two-year span. If you have two residences, both of them may qualify for the exclusion in the span of four or five years, but if you claim the exclusion on one of the properties, you have to wait two years before claiming the exclusion on the other property.

Many times people want to keep their personal residence because it has already appreciated and they think that it’s going to appreciate more. That can be a costly mistake. If possible, take full advantage of this generous tax break while it’s available. You could conceivably own three homes — your principal residence, a summer home, and a winter home. You could sell your principal residence, move into your summer home for two years, sell your summer home, move into your winter home for at least two years, and then sell your winter home to take advantage of the tax benefit three times in a little over six years.

Taking the ownership test

Owning a property means having your name on the deed. If your generous parents let you live in the second home they own, fix it up, and then sell it, neither you nor your bighearted parents qualify for the tax exclusion. You don’t own the home, and they don’t live there.

If you’re married and only you or your spouse is named on the deed, as a couple you still qualify to exclude the full $500,000 from your taxes. This rule applies to your principal residence — where you live — and it doesn’t necessarily matter whether both names are on the deed.

Splitting hairs: Special circumstances

What if you have to sell the house before the two years is up, perhaps because of a job change? Is that just tough luck? Nope. The tax code accommodates for circumstances beyond your control, including the following:

Divorce or legal separation
Multiple births from the same pregnancy
Death of the homeowner, spouse, or co-owner, making the home unaffordable
Serious health problems that require you to move in order to obtain proper treatment
Loss of employment that results in your receiving unemployment compensation
Military duty that calls you away from home for an extended period
Involuntary conversion of your home — when the government takes possession of your home by claiming eminent domain

In these and similar instances, you may qualify for a prorated exclusion. In other words, if you and your spouse live in the home for a year, you may qualify for half the exclusion or $250,000 rather than the full $500,000.

Slashing Your Capital Gains through Careful Deductions

You buy a house for $250,000, fix it up, and sell it for $300,000 in one year or less. Now you’re stuck paying short-term capital-gains tax on your $50,000 profit, right? Wrong. The $50,000 is your gross profit, but you pay tax only on your net profit — the actual profit you make after deducting all your expenses. This tax rule applies to any house you flip — the property need not be your principal residence.

Carefully log all your expenses related to the purchase of the property, holding costs, repairs and renovations, and the sale of the house, including the following:

Closing costs: You can deduct the appraisal fee, title search, deed-reporting fee, and credit-reporting fee. No double dipping. If you paid discount points, deduct them as mortgage interest, not as closing costs.
Cleanup: Deduct any expenses for house cleaning, landscaping, or trash removal.
Repairs and renovations: All expenses for improving the property for resale are deductible.
Utilities: Gas, electric, water, sewer, and trash bills for this residence for the entire time you own the property are deductible expenses.
Property taxes: Property taxes you pay out of pocket or out of an escrow account are fully deductible as expenses.
Insurance: Calculate the total amount of insurance you paid on the property during the time you owned it.
Agent fees: Any fees you paid to a real estate agent to purchase or sell the house are expenses you can deduct from your gross profit.
Other expenses: When you flip houses, you’re essentially running a business out of your home, so you can deduct all expenses related to flipping — mileage, phone bills, paper, ink, and so on. If you have an office in your home, you may be eligible for the home office deduction as well.

According to tax laws in effect during the writing of this book, you can also deduct the mortgage interest you pay on a loan of up to $1 million on your first and second homes. In effect, unless you neighbor with royalty, all or at least most of the mortgage interest on your first and second homes is deductible.

The $1 million cap on deductible borrowing applies to both married and single tax payers; if you’re married filing separately, the deduction is limited to interest on a home loan up to $500,000 for each of you.

When you’re flipping houses, you can deduct your mortgage interest in either of the following ways:

On a monthly basis, so you can keep track of your profit and the taxes you owe per month
By property, so it appears on your books either as an interest deduction or an expense you can deduct from your gross profit

Consult with your CPA or tax specialist on the best way to keep track of your interest payments and claim the deduction.

Deducting your expenses can make a big difference at tax time. If you flip a house for a gross profit of $50,000 but pay $20,000 fixing it up and selling it, instead of paying, say 28 percent of $50,000 — $14,000 — in taxes, you pay 28 percent of $30,000 — $8,400!

Don’t be a dupe. Save all your receipts and pay taxes only on the profit you pocket.

Paying Income Tax: When Flipping Houses Becomes Your Occupation

You decide to keep your day job and moonlight as a house flipper, buying and selling one or two properties a year to supplement your income. In such cases, the IRS considers your profits investment income subject to capital-gains tax. When you begin earning big bucks flipping houses and quit your day job, you suddenly become a house flipper, and your profits become self-employment income — subject to income tax and a whopping 15 percent self-employment tax.

If your annual income places you in the 28 percent tax bracket, for example, you can expect to pay about 40 percent in federal taxes alone. Why not 43 percent (28 percent tax bracket plus 15 percent self-employment tax)? Because you can deduct the 15 percent self-employment tax when figuring your income tax, which gives you a tiny break.

Because everyone’s tax portrait is unique, I can’t tell you whether the IRS earmarks your profits as capital gains or self-employment income, but I can provide you with a list of determining factors:

The purpose for which you purchase the property
The amount of time you hold the property
The number of deals you do over the course of the tax year
Your total sales over the course of the tax year
The amount of income from the sales of property compared with income from your day job

No hard-and-fast rules govern the way the IRS (or your state or local taxing authority) looks at these numbers. What’s most important is that you follow the rules to the best of your ability and accurately report your income and expenses. Consult your CPA or tax specialist for details to ensure that you meet the federal, state, and local tax requirements.

I hear plenty of stories about tax preparers who creatively underreport income and over-report expenses. If you bump into someone like this, turn around and start running in the opposite direction. If they’re willing to do it for you, they’re probably doing it for dozens of other clients already, and eventually they’ll get caught.

Right after you close on the sale of a property, visit your tax expert and find out how much of your profit you owe to Uncle Sam. Remit that amount as part of your next estimated quarterly payment at the time that payment is due.

Trudging through Some Taxing Issues