Before you flip that house, study up on tax consequences

Philadelphia home flipper Kelly Straka, 32, climbs a 2 x 4 ladder to the 2nd floor of a home she gutted and was completely renovating in the spring on E. Susquehanna Street in the Fishtown neighborhood of Philadelphia. Philadelphia is one of the hottest home-flipping markets in the nation. (CLEM MURRAY / Staff Photographer)

It’s not unusual to imagine that flipping houses would be fun. You might start by thinking that this could be the way to easy profits.

It’s an exciting venture, without a doubt, and one that, if done correctly, can bring you the kind of return on investment that you have been seeking. But buying a house, renovating it quickly, and then selling it again isn’t as seamless as HGTV’s Flip or Flop and Fixer Upper make it look, and it’s important that you be prepared for the never-televised wonkier side of property investing.

Which brings me today to an always-dreaded subject: taxes.

I know what you’re thinking. Taxes are why we hire accountants. But studying up ahead of a flip can save you from surprise later. Here are a few guidelines to get you started.

When it comes to flipping, the most important consideration, tax experts say, is how long you hold a property. If you retain the property for more than a year, federal law rewards you by treating any profit from the sale as a long-term capital gain. That means the tax rate on your profit is much lower, maxing out at around 20 percent for investors even in the highest-income tax bracket. For those in lower brackets, the rate could be lower — even 0 percent.

But if you flip in less than a year, tax rates are not in your favor. Money you make by buying and then selling that same property in less than a year is considered a short-term capital gain and is taxed at ordinary income-tax rates, which are much higher and can max out around 39 percent of your profit.

Yet the equation can get far more complicated than that, especially the more frequently you flip.

“What you should be mindful of … is whether or not what you’re doing could be considered purely an investment. Is [flipping] something you do in addition to your daily job?” said Bill Rucci, managing partner of Rucci Bardaro & Falzone, a Boston-area accounting firm, and someone who has spoken frequently on the subject. “… If the government can make the case that it’s more than just an investment, they will try to recharacterize the transaction as a trade or business. And how the profits are handled will be different.”

For someone looking to flip occasionally, it’s unlikely that the Internal Revenue Service would consider the activity a business, Rucci said, and thus would treat it like any investment, such as stocks or bonds.

At what point does it transition into a business? There’s no magic number, Rucci said, but “the more houses you are flipping, the greater the chance the government will call it a trade or business.”

The result: even more taxes. Not only are a flippers’ profits taxed as ordinary income, but they could also be subject to a self-employment tax.

There are ways to get creative. According to federal law, a homeowner can qualify for a federal tax exclusion on a sale’s profits if a home is considered a primary residence — meaning that the IRS would need proof of residency such as a car registration or utility bills. And a homeowner must have lived in the property for two of the last five years.

When it comes time to sell, the law allows a single homeowner to exclude up to $250,000 of profit from federal taxation. Married? That exclusion doubles to $500,000.

David Zalles, a Blue Bell-based CPA, said he once had a client who used that exclusion to her advantage: She would purchase properties, move in, and take her time over multiple years to rehab them before selling, living among construction noise — but allowing their value to appreciate. In the end, if her profit was $300,000, for example, she would be taxed on only $50,000.

The deal can be even sweeter in Pennsylvania, Zalles said: Generally, sales of primary residences are not taxed at the state level. In New Jersey, the law mirrors the federal statute, meaning the $250,000 and $500,000 exclusions also apply for state taxes.

Although investors should understand the tax implications, a decision to flip should never be made on taxes alone, said Chris Somers, a flipper and owner of Re/Max Access in Northern Liberties.

“If renovations are taking a little bit longer, at least there might be a tax advantage,” Somers said. “But sometimes, it’s important for people to move the asset so they can start another one. Sometimes the opportunity of that might be greater than the tax consequences of doing the sale.”