Although less popular now than it was before the markets crashed in 2008, purchasing homes to refurbish and resell for a profit – called "flipping" – allows speculators to put their time and labor into turning a profit off their investments. The practice involves purchasing a home at below neighborhood prices, making improvements on the property, and selling at an appreciated value. While the business risks involved with flipping homes are still familiar to many Americans, the tax consequences are less clear.
Investor vs Broker
Depending on how often you flip homes, and how much time you spend buying and selling homes, your home may be an investment or inventory. If you buy a home to flip in your spare time and keep your day job, you most likely qualify as an investor. When flipping homes becomes the ordinary course of your business, you cease qualifying as an investor and qualify as a broker instead.
Regardless of whether the home qualifies as investment or inventory, your gain or loss is the difference between net selling price and your adjusted basis. Basis includes not only the amount you paid for the home, but also certain closing costs and costs of improvements. Only services you actually pay for qualify for inclusion in adjusted basis, so you cannot add the estimated value of your own labor to the basis of a home you’ve refurbished.
Typically, people intending to flip homes purchase the home using a highly-leveraged mortgage to put as little cash forward as possible while repairing and selling the home. Each mortgage payment consists of a payment made toward the principal amount of the loan, as well as an interest charge. The tax treatment of the interest portion of mortgage payments depends on whether the home is an investment or inventory.
Interest charges incurred because you purchase investment assets using debt are considered investment interest expenses. You can deduct investment interest expense only up to the amount of investment income taxed at ordinary rates. If you qualify as an investor and you owned the house for more than a year, your profit is typically taxed at preferential capital gains. You can elect to treat part of the gain as ordinary income so you can reap the tax benefit of the interest investment expense. If you flip a house in less than a year, the profit is short-term capital gain, which is taxed like ordinary income so you can offset gains with mortgage interest.
On the other hand, if you qualify as a broker, then the home is treated as inventory. You must report all gain from the sale of inventory as ordinary business income. However, you get to deduct mortgage interest as a business expense that is considered ordinary and necessary, rather than subject to the limited rules of investment interest expense deductions for non-brokers.
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