Investing Trends

A common method of investing in real estate is doing a flip - buying and selling the same property in a short period of time. For the purposes of this article, there are basically two types of flips. You can buy a house at a wholesale level and flip it to another investor at a sort of wholesale level to pocket a small profit. Or you can rehab a house that you purchased cheaply or bought from a wholesaler and sell it to a retail buyer. In both instances, the goal in the investor's mind is to hold the property for a fairly short period to free up the cash for the next deal.

The challenge in this situation is that unless creative tax strategies - like a 1031 exchange - are followed, you will usually pay taxes on the gains at the short term capital gains rate - the most expensive tax on your profits that there is. In some cases this is OK. In others it is avoidable.

Let's examine the three levels of taxation that can affect a flip type house situation and discuss strategies that may maximize your after tax return on investment.(As always, it is best to discuss any scenario with your real estate investment savvy accountant to be appraised of the most current tax laws as they affect your particular flip scenario.)

When it comes to taxes and real estate investments, time is your friend. If you own a property for more than a year, you will get preferential tax treatment when you sell the property. Unfortunately, for the real estate investor, time is your enemy as more time means more holding costs and less profits realized. The trick is to find the proper balance and solution for each property to maximize the amount of profit you get to keep when the sale finally occurs.

There are basically three tax scenarios for buying and then selling a property in a specified period of time.

The first scenario is for a buy/sell cycle that runs for less than one year. If you purchase a house and then resell it before one year passes, your profits will be assessed at the short term capital gains rate. Short term capital gains rates are the highest amount you will pay in taxes on your profits.

The second scenario is where you have owned the property for more than one year. In this instance, you will pay taxes based on the current long term capital gains rate. This rate is generally significantly less than the short terms capital gains rate.

The third scenario is the best. If you are dealing with an owner occupied property - such as a flip where you live in it and make the repairs - you can keep all your profit tax free. It is required that you own and live in the property for at least two years out of any five year period. If you can meet this scenario, you can keep up to $500,000 in profit if you are married or $250,000 in profit if you are single. This profit is totally tax free and can be used for any purpose you wish. It is an extremely powerful tax investment strategy if it fits into your lifestyle choices.

After reviewing these three scenarios, you can tell that the best scenario from a maximum profit standpoint is the last scenario. If you are the type who wants to live in the house you are fixing and wait two years before selling, it is certainly a very powerful way to build great wealth over the long term. If you choose the right house in an area of rising property values and add value to the property, you can earn a significant amount of profit in two years and enjoy it tax free when you sell the property. It certainly makes a huge nest egg for your retirement or your next property purchase(s).

The only problem with this scenario is that you can do this on only one house at a time. So if you plan on flipping more than one house every two years, chances are very high that you will be encountering one of the first two scenarios on every deal. And if your investment strategy is to do more than one house every two years, you should not let tax consequences stop you. But you do need to plan for them in your profit formula for each house.

If you are wholesaling properties, you will hopefully always fall into the first category. And that is OK for a wholesaler. A wholesaler's goal is constantly making your money work for you. If a house sits too long, it costs you momentum and profits. You are earning your profits on the volume of properties you are flipping. Tax consequences in this scenario are simply a cost of doing business.

People who rehab houses to sell at retail have a more difficult decision to make. If you can rehab and resell a house for very quickly to get your money working for you again, it probably makes sense to take the hit on taxes that you encounter when you pay short term capital gains because you have your money back and working for you again. Again the tax on the profits is just a cost of doing business. And if you make $20,000 in profit and have to pay $6,000 in taxes, you still made $14,000 in profit. And you recovered your original investment. So even with a large tax hit, you still walk out of the deal with more than when you began the rehab project.

Of course, some rehabs take longer - several months or more. And sometimes , the profit in the house will be very large when the rehab is complete. In these instances, you need to calculate the cost of holding the house until one year has passed vs the additional tax liability that is created from selling it before one year passes. In this instance, you may choose to just hold the house empty until you can sell it for maximum profit. Or you may choose to do something creative in the sales process and either rent it out for a while (knowing that you will have to polish up the house before final sale) or offer it for sale via a lease option. Either technique will stretch the length of time that you hold the house, help cover the costs of that holding period (or even put profit in your pocket) and let you get that preferential tax rate when you finally sell the property.

Understanding and applying the current tax laws to your real estate transactions is an essential piece to understanding the total profit picture of a deal. If you don't understand them and plan for them, you could be in for a very large surprise tax bill at the end of the year - one large enough to cripple your real estate investment activities for a long time. Your best resource for understanding the tax ramifications of any investment is your real estate savvy accountant. You should have a person like this on your investment team to be sure you are maximizing your cash flow. If you don't you could be losing $1000's of dollars you didn't have to lose.