There’s a difference? Really?
There IS a difference, and knowing which to choose can save you tens of thousands of dollars in taxes.
Per transaction. That’s right.
We’ve covered some of your big money makers and savers already, such as holding out for a full year prior to sale to reduce taxes from ordinary income tax rates to favorable capital gains rates, but what you do with the gain on your property sale makes all the difference.
This is what will distinguish you as an investor, relative to a “dealer.”
You can buy, renovate and re-sell, aka as flipping. You can buy and hold, and let appreciation make your money for you.
You can also buy and hold and lease the property out to renters. Let’s explore that one first.
Property you buy and hold for rental activity is passive income!
Passive income is awesome, though there are some tax considerations such as limits on passive losses to keep in mind. We love passive income because it is NOT subject to self-employment tax.
No fear, you may still write off the expenses of your rental activities, either on Schedule E, or Form 8825 for your partnerships and S Corporations.
Keep in mind, too, that you’ll still be eligible for the qualified business income deduction if a combination of your time and the time of the people you hire exceeds the 750 hour per year requirement.
Nevertheless, this income is considered passive. And that saves you 14.13% on that self-employment tax you’re not paying.
If you take in $100,000 in rental revenue after all expenses are accounted for, that means you save $14,130.
I don’t care how affluent you might be, or how diversified; $14K is enough to do something nice with the family. Maybe even two times, or more!
Rental revenue is always passive income and is taxed at the ordinary income tax rate. Only.
You are, in the eyes of the tax people, a real estate investor.
Property you buy, renovate, and re-sell is… passive income?
Well…it can be. But…
It is NOT passive if you report the gain on the sale as income in the year of the sale.
In the words of Steve Miller, if you “take the money and run.”
No question, there are folks making a very comfortable living this way.
People for whom their superpower is identifying properties at a bargain, renovating them, and covering their 70% rule margin nicely.
The 70% rule is, of course, a loose guideline, but if you’re new to house flipping and don’t know about this please do allow me to share.
It will help, I promise!
Begin with the “After Repair Value” (ARV), your best estimate of what you can list and sell for once completed.
Multiply that number by 0.7, or 70%. Then subtract the anticipated costs of renovation.
(ARV X 70%) – renovation = Offer
Example: there’s a home with comps in a neighborhood that has you convinced you can get $400,000 for in clean condition comes, just popping on to the foreclosure market. You estimate $60,000 in renovation expenses.
$400,000 X 70% = $280,000. $280,000 – $60,000 = $220,000, and there’s your 70% Rule Offer.
Again, it’s a guideline, but if you fudge on this, you’re going to have a more difficult time making money at this game.
Let’s circle back around to my main point: if you’re in it to cash out, you’re reporting this as business income subject to ordinary income tax rates PLUS self-employment taxes.
If you make $100,000 on a sale and pay an effective tax rate of 15% on your 1040 that’s $29,130 in taxes.
Yikes!
So…can your profits from re-sale ever be considered passive?
The answer is yes, if you do the right things with the money, AND those things are clearly documented.
You can do it, but ONLY IF you re-invest the profits as capital for other ventures.
Then, see, you’re investing in the eyes of the tax folks, and you’re back in the wonderful world of passive income again.
Some examples would be:
- Purchase new rental property
- Improve existing rental property
- Invest in new renovation property
- The 1031 like-kind exchange
If you’re in it to win it, you can see that there are options available for you to not get brutally injured by excess taxes.
Now…how would you like to have the flexibility to be able to invest some proceeds, and cash out others while saving at least half, and quite often a lot more, of those self-employment taxes?
It’s real, it’s legitimate, and it will save you thousands of dollars in excess taxes.
The best part, Part Two of this series, is entitled “Form One Master Business Entity.”
I’m going to give it to you as a Christmas present because, let’s face it, once the family presents have been opened and the mess cleaned up there’s a lot of very peaceful time to kill.
So, it’s my free gift to you, for later in the day 😉
In the meantime, happy Winter Solstice everyone, and may your Christmas Eve be merry and bright.
See you Christmas Day! 🎅❄️🎁⛄🎄