Normally, if you purchase a piece of real estate to fix up and sell it at later date, the profit is taxed under the capital gains rules. There are even more favorable rules if the property qualifies as your principal residence. If you live in it more than two years during the five-year period preceding the sale, you can often exclude the gain from taxation altogether under special rules for homeowners.
However, the IRS classifies individuals who actively purchase and remodel real estate for profit on a continuing basis as dealers rather than investors. For these people, the real estate is treated as inventory, rather than capital assets, and the profits on the sale of those properties is treated as ordinary income, subject to the self-employment tax.
Another source of confusion is that many potential flippers believe they can avoid taxation if they roll the proceeds of the sale into purchasing another project to flip (i.e., the property ladder theory). The truth is, if you’re considered to be in the trade or business of flipping real estate, this is not possible, as this treatment isn’t allowed for property held for resale.
House flipping is obviously a costly business, with numerous expenses incurred along the way. Most of these expenses are not immediately deductible. Instead, they must be capitalized into (i.e. added to) the basis (the original value) of the residence. Capitalized costs include:
• The cost of the home itself
• Direct materials
• Direct labor
• Indirect labor
• Equipment depreciation
• Production period interest
• Real estate taxes allocable to each project
You then get a tax benefit from these expenses when you sell the property as the taxable gain is reduced by the amount of basis in property.
Lastly, anyone watching reality TV knows that there dozens of pseudo-celebrity house flippers, all of which seemingly offer their own courses and seminars purporting to teach individuals how to make it big in the business. It is important to note that for most individuals, expenses incurred in attending these courses are nondeductible under both the education expense and investment expense rules. Also, these courses will not qualify for the any of the education tax credits.
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