House Flipping Taxes: Capital Gains or Ordinary Income?

Capital gains are taxed at rates equal to or less than the ordinary income. Therefore, it’s always better for profit to be taxed as capital gains instead of ordinary income.

The key to saving taxes on flipping houses is to try to classify the house as something other than inventory. Generally, a house can be classified as one of three different property types:

1. Inventory: Profit from inventory is taxed as ordinary income and subject to self-employment tax if sold by individuals.
2. Passive investments: Gains on the sale of passive investments are taxed as capital gains. Houses are passive investments if they are rented out or held with the hopes they will increase in value.
3. Primary residence: Most gains from the sale of a primary residence are excluded from tax but generally require you to live in the house for two out of the prior five years.

Pat loves watching HGTV and has decided to flip their first house. Here is a history of the purchase, fix-up, and sale:

• Purchased: Aug. 1, 2024, for $100,000
• Fixed up: Aug. 1, 2024, to Oct. 18, 2024, for $45,000
• Sold: Nov. 15, 2024, for $200,000 net of selling expenses

Let’s assume that Pat has an ordinary income tax rate of 24% and that they purchased the house personally rather than through an S-corp or other entity. Pat has a profit on their flipped house of $55,000 (200,000 – 100,000 – 45,000). The profit is subject to both ordinary income tax and self-employment tax.

This is a worst-case scenario from a tax perspective. Let’s look at how the total tax paid would differ if the house was a passive investment or a personal residence. Then, we’ll explore ways you might attempt to convert the property.

While a house can be held as a capital asset, such as vacant, this is pretty rare. This more commonly applies to vacant land, which is a bit outside the scope of our discussion on flipping houses.

Let’s assume the same basic facts as in our example above, except that the house was purchased and fixed up with the intention of holding it as a rental property. The house was held for three years before being sold for $200,000. We’re going to ignore the depreciation expense that Pat would have claimed on the rental property so that we can keep an apples-to-apples comparison of the tax liability.

Based on Pat’s 24% ordinary tax rate in the first example, their capital gains tax rate is 15%.

By holding the house as rental property instead of inventory, Pat saved a whopping $13,365 in tax. The majority of this ($8,415) was due to the profit not being subject to self-employment tax. We’ll talk about other strategies to avoid self-employment tax later in this article.

If you meet the two-out-of-five-years test (a bright-line test), it allows the profit on the sale to be excluded from income. It doesn’t matter what other purposes the house was used for—as long as you lived in it for two out of five years.

Let’s assume the same facts as in our first scenario of Pat flipping a house. However, after realizing the potential 40% tax on the profit, Pat decides to move into the house once the fixing-up is complete. They live in the house for two years and then sell it for $200,000.

The $55,000 gain is completely tax-free. By moving into the house and living there for two years, Pat has saved $21,615 in taxes compared to immediately selling the flipped house. Of course, there may be a heavy personal cost to moving into the house—especially for taxpayers with a family and school-aged children. Also, this isn’t feasible if you’re a frequent flipper because you have to wait two years between sales.

As we showed above, the profit on the sale of rental property is taxed at the lower capital gains rate and is not subject to self-employment tax. However, you’re going to need to rent the house out for a substantial period before selling it to make this work.

So, how long do you have to rent out a house before it is no longer inventory? There is no clear-cut answer, but you need to demonstrate a clear intent to hold onto the property and make a profit through rental. Renting out your flipped house while still actively trying to sell it will not be enough to convert the house from inventory to rental.

This is the most clear-cut way for a one-time house flipper to avoid tax on the sale of the flipped house. The rules are very simple: move into the house and use it as your primary residence for two years and you can exclude up to $250,000 of gain ($500,000 for married taxpayers who also live in the house).

This might work very well for a single person living in an apartment. But, of course, if you’re married with school-aged children, moving homes might be a very big ordeal. You’ll need to determine if the tax savings is worth it.

Self-employment tax is due on income for an activity carried on as a trade or business—but not on an activity carried on as a hobby. Even if the house remains classified as inventory, you might save the 15.3% self-employment tax by invoking the hobby rules, though it isn’t easy to do.

A quick caveat: I think it will be hard to establish that a profitable house flip was done as a hobby. However, let’s talk about the rules, and you can decide for yourself if you want to pursue this avenue.

Let’s start by assuming that your house flip qualifies as a trade or business. However, you might be able to claim the activity is a hobby if

• The gain from the house flip was unnecessary for your financial support or livelihood
• Making a profit on the flip was not a primary consideration
• You spent a minimal amount of time and effort on the activity
• You had no business plan or projection that showed the activity will be profitable
• You had no prior history of making a profitable house flip
• You enjoy the work involved with flipping a house

You don’t need to answer “yes” to all the above questions to qualify as a hobby, but not being motivated by making a profit is a very important determining factor. You might consider claiming your activity is a hobby if you truly enjoy the work and are unsure if you’d even make a profit.

Perhaps you love the work and decided to flip the house to help restore a rundown neighborhood. If restoring the neighborhood was your primary motivation—and you happened to make a profit—then you might have an argument that you are engaged in a hobby, not a trade or business.

This is likely the single biggest thing you can do to minimize your taxes on flipped houses, specifically to minimize self-employment taxes. House flipping income earned by an S-corp (or an LLC treated as an S-corp) can be distributed to the owner in two ways:

1. The owners must pay themselves a fair wage or salary for the work they perform to flip and sell the house. These earnings will be reported on Form W-2 and employment taxes must be paid the same as for any employee. The employment taxes paid by the S-corp and the employee lead to a total of 15.3% (the equivalent of the self-employment tax paid by individuals), so there are no tax savings here.
2. Any remaining income in the S-corp must be reported by the owner and is subject to ordinary income tax rates. However, this S-corp income is NOT subject to self-employment tax, which is what generates the tax savings under this plan.

This is a good tip for any small business. By paying your children a reasonable wage for helping with the house flip (perhaps keeping the job site clean or other age-appropriate duties), you can claim a deduction for your business while your child doesn’t pay income tax on their first $13,850 of wages.

Unfortunately, S-corps will have to assess FICA taxes on the child’s wages of 7.65% paid by the child and 7.65% paid by the S-corp. This combined 15.3% will eat into your tax savings—but if your marginal tax rate is higher than 15.3%, then you’ll still save some taxes.

Let’s assume Pat has converted their flipping business to an S-corp and still has a marginal tax rate of 24%. If they pay Pat Jr. $10,000 in wages, Pat saves $2,500 ($10,000 × 25%) of income tax. However, the S-corp and Pat Jr. must pay combined FICA taxes of $1,530 ($10,000 × 15.3%). So, Pat’s net tax savings is $970. If Pat were flipping houses as an individual rather than an S-corp, then paying Pat Jr. would save $2,500 in taxes with no offsetting FICA tax liability.

Generally, selling a flipped house comes with an influx of cash. One way to avoid paying tax on that cash is to offset the income with a deductible retirement contribution.

While there are several types of retirement plans to choose from, an easy-to-administer plan is a Savings Incentive Match PLan for Employees individual retirement account (SIMPLE IRA Savings Incentive Match PLan for Employees ). For 2023, you can contribute and deduct up to $15,500 to a SIMPLE IRA. Both sole proprietors and S-corps can participate in SIMPLE IRAs.

One potential problem is that if you have employees who earn over $5,000 per year, then you’ll need to give them the option of participating in the SIMPLE plan. You’ll need to match the first 3% of the wages they place into the plan if they elect to participate. Head over to the IRS’s SIMPLE IRAs page to learn more.