Accounting for House Flips
House flipping is a popular real estate investment strategy where investors buy, rehab, and sell properties for a profit. Whether you’re interested in flipping one property or starting a business dedicated to flipping, it’s important to have a good accounting system in place before you buy your flip. Having clear records shows your investors and lenders that you run a professional, organized operation. But tracking the revenue and expenses for a flip differs from handling the books for rental properties. Let’s look at what you need to track, what the differences are from rental property accounting, and what the tax considerations are for flipping.
What Transactions to Track
House flippers need a sustainable and scalable system to record five types of transactions.
● Acquisition
Keep records of all HUD statements, any documents related to the property purchase, tax assessments, appraisals, and insurance paperwork. Remember to record the cost of any title insurance fees, commissions, or permits.
When you buy the flip, if you pay real estate taxes that the seller owes, and the seller does not reimburse you, the taxes you pay should be added to the property basis. However, if the seller pays the property taxes and you reimburse them, then you can usually deduct the expense in the year of the purchase, so the property basis isn’t affected.
● Rehab
Flips can involve extensive remodeling and improvements. You’ll need to record costs related to building materials, professional labor, appliances, cosmetic repairs, and landscaping. Record your mileage as well! The IRS mileage deduction accounts for the fuel used to travel for flip-related errands plus the wear and tear on your vehicle.
If you flip properties through a business (LLC, Inc., etc.), you may need to issue 1099 forms to your professional laborers and contractors.
Remember, capitalized costs, such as a new HVAC system, roof replacement, or bathroom remodel, aren’t immediately deductible. Instead, add these investments to the original value of the property. This reduces your taxable gain by the basis in the property.
● Holding
Holding costs, also known as carrying costs, include financing costs, loan interest, taxes, insurance, utilities, snow removal, lawn care, HOA dues, and cleaning fees. The invoices should show the amount paid and that the payment was a flip-related expense.
Monthly mortgage payments would count as a holding cost, but loan repayments are more prevalent with flips because of the shorter repayment periods.
In 2018, the IRS introduced the Uniform Capitalization Rules, which give flippers the option to deduct carrying costs if flippers meet certain criteria. Under these rules, flippers can deduct costs for general maintenance but capitalize interest and taxes. Consult with your CPA to see whether deducting or capitalizing these costs is right for your flip.
● Selling
When it’s time to sell your flip, remember to record broker fees, legal costs, title insurance, and loan origination fees (closing costs). Depending on where the property is located, you may pay and record transfer taxes. Take note that in some parts of the US, property taxes are included in the selling price and are paid by the seller. And if you financed your flip with a mortgage, you may face early-repayment penalties since mortgages are usually long term. If you bought or rented any furnishings to stage the house, those fees count as selling costs.
● Income
The goal of flipping a house is to sell the property for a profit. Make sure you remember to record your income and keep copies of the paperwork related to the sale.
Selected Tax Considerations
Profits from house flips count as either ordinary income or capital gains depending on the taxpayer’s situation. The IRS has three categories to determine how to tax flipping income. Speak with your tax preparer to confirm the proper treatment for your flips.
1. Live-in Flips
Using the flip as your primary residence puts you in a capital gains situation. In this scenario, you own the property and live in it for two of five years, which qualifies you for the capital gains exclusion of $250,000 when you sell the property.
2. Investments
If you buy a flip and have no intention of moving in, and you fix up the property and flip it within twelve months, the IRS will treat you as an investor. This won’t count as your regular or routine form of business, so the profits from selling your flip will still count as capital gains. However, you will not qualify for the capital gains exclusion. And depending on how long you take to flip the property, you must pay either short- or long-term capital gains taxes. Holding the property for one year or less qualifies you for the short-term capital gains tax; if you hold the property over one year, the long-term capital gains rate applies.
As an investor, you could qualify for the Section 1031 exchange, or like-kind exchange. This tax benefit lets you sell a property held for investment purposes and swap it for a new one bought for the same purpose. This lets you defer the capital gains taxes on the sale. If you’re considering the Section 1031 exchange, check with your CPA or attorney since specific rules apply to the exchange.
3. Trades or Businesses
When you routinely buy, flip, and sell properties as your primary business, the IRS will treat your profits as ordinary income. The IRS will tax that income at your ordinary tax rate and consider it active income, unlike income from rental properties, which is passive. In this situation, you may also be subject to self-employment taxes.
Unfortunately, there isn’t a magic number of properties that indicates whether flipping is your primary business. The IRS determines on a case-by-case basis how many flips per year renders someone a professional flipper. However, your business entity helps determine whether you are a business or an investor, which affects how the IRS will tax you.
Potential flippers may be drawn in by the property ladder theory. That’s the idea that flippers can roll the profits from one flip into the purchase of another property and avoid the related property taxes. This falls under the Section 1031 exchange, but that only applies to investors, not businesses. If the IRS deems that you are in the business or trade of flipping houses, you won’t qualify for Section 1031.
Takeaways
Income from flipping houses and rental properties is taxed differently. Plus, flipping houses can have a significant impact on your tax situation, so consult with your CPA or attorney before you buy a flip. Remember to keep all property-related documents organized and record each transaction in your accounting system. Accounting for flips is a little different from bookkeeping for rental properties, but one thing holds true in both cases: having an organized accounting system to track income and spending is critical.
