House flipping is a term that typically refers to the practice of buying and quickly reselling homes for profit. In many cases, the flipper purchases a residence that needs work, makes the necessary upgrades and repairs, and then sells the property for more than they invested. According to ATTOM Data (a provider of nationwide property data), the average profit for a house flip in 2022 was $70,000. That’s a tidy profit for what is often a short-term project.
However, that profit is a capital gain and usually a short-term gain. That means the yield is subject to a levy at the same rate as the rest of your ordinary income—which could be as high as 37 percent. On the other hand, if the flipper owns the house for more than a year, the gain is typically considered long-term, and the rate is imposed at the lower rate, which tops out at 20 percent. Still, most flips are completed in less than a year; either way, the tax takes a chunk out of the gain.
Some house flipping advisors may tell potential investors that they can defer the recognition of the capital gains (and the tax) by reinvesting the proceeds using a 1031 exchange. However, this approach is risky since flipping typically doesn’t satisfy the IRS requirements for a 1031 exchange. A flip involves property being held for resale, which does not qualify. Instead, property eligible for a 1031 exchange must be held for investment or used as a business. For example, if you own residential property that you rent out to earn income, that is likely to qualify for a 1031 exchange. Similarly, you can use the approach to reinvest proceeds from selling other commercial property.
As with other real estate investments, taxpayers can deduct expenses from income. In this case, you can deduct the cost of acquiring, improving, and selling the property from the proceeds.
Whether the capital gain is short- or long-term, the investor may be able to defer the capital gains taxes by investing the proceeds in a QOZ project. While some of the original incentives for QOZ investments have expired, there are two potential advantages to investing capital gains into a QOZ. Both of these should be evaluated as a bonus when considering an investment that already makes sense. In other words, the tax advantages may not be adequate to overcome the potential risks of a questionable project, so always ensure that the investment aligns with your risk strategy.
For example, if you earn $70,000 from flipping a house and you then reinvest it into a QOZ fund this year (within 180 days of receiving the funds), you can defer payment of taxes on that $70,000 until after December 2026. In addition, any profit from the reinvested $70,000 will be free from capital gains taxes if you hold the investment until 2033.
Flipping houses is potentially profitable, but there are pitfalls, including the taxes that may be assessed on any profit.