I haven't had the chance to talk about fix and flips yet. My apologies to the fix and flip real estate investors for the delay! This article will be a comprehensive guide for understanding the tax implications of fix and flips. There are three main stages: purchase, rehab, and sale.
Purchase
I’ve mentioned it before and I’ll keep harping on this point. With the purchase, the most important thing is figuring out your basis. The basis is important for determining your depreciation deduction. This article will help you figure out your basis in the building. Please note that you do not have to break out between building and land as the houses are considered inventory.
Rehab
This is often the most challenging part of this process, based upon my conversations with those that fix and flip. The biggest thing from a tax perspective is to keep track of ALL your expenses related to the flip. These items will be added to your basis. See below for the main expenses I have identified. By no means is this an exhaustive list:
- Direct materials
- Direct labor
- Utilities
- Insurance
- Equipment Rentals
- Mileage (see previous article for additional details)
- Insurance
- Mortgage interest - Make sure to get a statement of interest if you are using a hard money loan
- Real estate taxes - you must calculate them as follows:
Taxes paid during the hold period + real estate taxes paid upon sale - real estate credit when purchased
- Staging
There are also other expenses that may not be directly allocable to one property that you may be able to deduct depending on your facts and circumstances. These include:
- Legal and professional fees
- Travel and meals (i.e. out of state investor visiting the properties or looking at additional subject property in an area where the investor already holds property).
- Telephone (deduct what is business related)
- Education/books
- Seminars
Sale
To calculate your ending sales price, you must subtract out all fees paid. These include but are not limited to: fees paid to real estate agents, recording fees, transfer taxes, attorneys. Once you do this, you must also be aware that the income from the flip is recognized in the year sold. To illustrate the process from start to finish, let’s look at two examples.
Sale: Example #1
Below are the assumptions:
Purchase Date: 5/10/2021
- Purchase price: $80,000
- Rehab costs: $50,000
- Other costs (i.e. insurance, taxes, interest): $8,000
- All in costs (purchase price + rehab costs + other costs): $138,000
- Sales Date: 9/15/2021
- Sales Price: $175,000
- Sales expenses: $10,000
- Net sales price: $165,000
- Profit (net sales price - all in costs)
$165,000 - $138,000 = $27,000
- Total amount to be reported as income in 2021 = $27,000
Based on the above facts and circumstances, the flip took four months from purchase to sale. The rehabber’s “All In” costs were $138,000. They ended up making a tidy profit of $27,000 based upon their $165,000 sales price. Income is recognized in 2021 because the property was sold in 2021.
Sale: Example #2
Below are the assumptions:
- Purchase Date: 10/10/2021
- Purchase price: $80,000
- Rehab costs: $50,000
- Other costs (i.e. insurance, taxes, interest): $8,000
- All in costs (purchase price + rehab costs + other costs): $138,000
- Sales Date: 2/1/2022
- Sales Price: $175,000
- Sales expenses: $10,000
- Net sales price: $165,000
- Profit (net sales price - all in costs)
- $165,000 - $138,000 = $27,000
- Total amount to be reported as income in 2021 = $0
- Total amount to be reported as income in 2022 = $27,000
The above facts and circumstances are identical except the date purchased and sold. The property was purchased in October 2021 and sold in February 2022. They still made a profit of $27,000. However, since the property was sold in 2022, the income is recognized in 2022.
Other Important Information to Know
For reporting, profits/losses are generally reported on Schedule C (as part of your individual tax return), if you are a sole proprietor. If you are an S Corporation, then it is filed on Form 1120S. As illustrated above, it is important to know that income is reported for properties sold during the year (hence why I’ve repeated it so many times). Houses are considered inventory as defined by the IRS.
Depending on the level of income generated from your fix and flip business, you may want to consider discussing with your accountant about making estimated payments. These payments are paid quarterly and should be based on the income you generate/expect to generate during the year. If you are a W-2 employee while doing fix and flips, it is unlikely your withholding through work will be able to cover you for any substantial increase in income outside of your W-2. By doing this for federal and state, you will increase your likelihood of avoiding underpayment penalties.
For the amount of profit you should put aside for your taxes, you generally want to put 40-55% away depending on your tax rate. At the very least, you can expect to pay 5% for Illinois, 15.3% for self-employment income (if sole proprietor), and your marginal federal tax rate (the rate at what each additional dollar is taxed at).
Wrapping it Up
When you purchase property for the intent of flipping, you must be diligent in keeping track of all costs. As a best practice, you should keep track of the costs on a per property basis. Further, by understanding that the income is generated in the year sold, there may need to be additional tax discussions with your advisor throughout the year or near year end. You want to make sure you are covering yourself by withholding some of the profit (40-55%) for taxes (federal and state). My hope is that the above clearly illustrates the important concepts for your fix and flip.
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at aaronz@thethinkers.com.
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