Rather than hold real estate for rent or long-term capital gain, some real estate investors buy property, fix it up, then sell it off quickly for a profit. The practice, known as flipping, can be a lucrative endeavor for both the investor and the tax man. In most cases, the Internal Revenue Service will demand a hefty slice of any profits you make on a house-flip sale.
No Tax Exemption for Investors
Few people pay tax on the profit they make when they sell a home. That's because the IRS lets taxpayers keep the first $250,000 gain tax-free, or $500,000 for married couples filing jointly. However, the exemption only applies when you sell your principal residence. If you sell a property that you have never lived in, or have not lived in for at least two of the five years immediately preceding the sale, you must declare the gain on your tax return.
Greater Gain Means More Tax
Your gain is the dollar difference between the money you spend on the property and the amount you sell it for. Suppose, for example, you buy a house for $150,000 and spend $50,000 on a new kitchen, paint and other improvements to make the home more appealing. If you sell the home for $230,000, your taxable gain is $30,000. As an investor, you pay tax on the full amount of the capital gain. You can deduct all your expenses such as property taxes, real estate commissions and other fees to reduce your gain.
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Two-Fold Tax Liability
How much tax you pay depends on how long you hold the asset. The tax man rewards investors who keep their investment properties for more than one year by applying a lower long-term capital gains rate. This can be anywhere between zero and 15 percent, depending on your individual circumstances. If you buy and sell the home within one year, your gain is taxed at your ordinary income tax rate. At the time of publication, that rate could be as high as 39.6 percent.
When Flipping Becomes a Business
The IRS has the power to classify serial flipping -- completing back-to-back flips or several buy-sell transactions in a short time -- as a business rather than an investment strategy. If that happens, all of the profit is considered active income irrespective of how long you hold the property. The gain is taxable at your ordinary income tax rate and you may also be liable to payroll and self-employment taxes at the prevailing rate. There's no hard-and-fast rule to determine the tipping point from investment activity to business activity. The IRS looks at each matter on a case by case basis.