Flipping real estate can be a tremendously lucrative venture. Many investors make an entire career out of finding under priced properties that need a little love, updating them and selling to a buyer at a profit. Making tens of thousands on a successful flip isn’t uncommon But before you set your sights on a long career in flipping, investors need to understand the tax implications of these lucrative deals.
Table of Contents -House Flipping and Your Taxes: What You Need to Know
It’s always nice to close the deal on a flip with thousands in profits, but those profits aren’t immune to taxation. There are some very stringent tax laws regarding real estate flips. Not only do you need to report the sum of your profits from a flip, but you’ll also need to include fees or commissions generated on these transactions. It can get complicated quickly. Here’s what you need to know.
Flipping and ‘shadow flipping’ defined
Getting back to basics, a house flip is a simple concept. You buy a property for below its assessed market value—usually, because it’s under-maintained, outdated or has a major defect. Then, you fund the improvements necessary to raise its value, turning it into a marketable property that someone will buy using a conventional mortgage loan. Between the low investment cost and improvement capital, you end up selling the property at a profit. Here’s a practical example:
Jim buys a single-family home for $100,000. Comps put the home’s market value at $180,000, but the home has a foundation crack and water damage, making it undesirable to home buyers. After buying the home, Jim dumps $60,000 into it, in the form of foundation repair, water damaged remediation and general update. A few months later, he lists the home at $180,000 and sells it for a total profit of $20,000.
Flipping can become more complicated when you consider alternative financing or private buyers, but the principle is relatively the same. And, in the eyes of the Canada Revenue Agency (CRA), so are the profits generated. This even applies to ‘shadow flipping’ (assignment sale), which involves selling a property before it’s built or put on the open market.
What are the tax implications?
All profits made on a flipping deal—including commissions and fees—need to be reported to the CRA. These profits are fully taxable as business income, making it even more important to have your real estate business properly structured. Using the example from above, Jim will need to report his $20,000 profit from the flip as business income, which means paying the effective business tax rate when he files.
Things can get more complicated depending on the situation. In some cases, flipping transactions may also qualify for Goods and Services Tax (GST) and Harmonized Sales Tax (HST). The CRA has guidance for when GST/HST tax applies on their website, and investors should be aware of when the details of a transaction may trigger remittance of these taxes. There is one exemption—the principal residence exemption does not apply to property flipping. Essentially, if you purchase your home below market value and live there while making improvements, the profits from the final sale would not count as business income so long as you meet the following requirements:
- The income-producing use is ancillary to the main use of the property as a residence.
- There is no structural change to the property.
- No capital cost allowance is claimed on the property.
For most flippers, time is of the essence. That means the principal residence exemption likely doesn’t apply to the situation. Translation: be prepared to pay taxes owed on the profits of your deal.
A note about capital gains
Most flippers don’t have to worry about capital gains tax, but it’s still worth mentioning. If you buy a property with the intent of renovating it and selling it, the CRA will see it as a business investment, thus making profits from the sale business income. However, if you buy a property and use it as a revenue stream (rent it), then sell it, you might get hit with capital gains tax. Here’s an example:
Jennifer buys property at $200,000 and makes $20,000 in upgrades. She then rents the property out for $1,500/mo. for 10 months while she lines up a buyer, generating $15,000 in revenue. She then sells the property to a private buyer for $235,000, for a total profit of $30,000 after upgrades and rental income. The profits are recognized as capital gains.
This is a big deal. The effective tax rate for capital gains is 50 percent, meaning you could ostensibly end up halving your profits! In the example above, that means pocketing just $15,000 of a $30,000 profit!
Thankfully, you can dispute the taxation of capital gains if you can prove the sale generated taxable business income. The simplest way to avoid this debacle is to stick to the flipping approach: don’t try to renovate; rent, then sell.
Is flipping worth it?
Many new real estate investors are disheartened after their first successful property flip. They generally make the flip with thin margins, making only a few thousand dollars off the deal. Then, they report the profits and pay taxes, leaving them with a seemingly insignificant amount for what feels like (and is) a lot of work. It can put a damper on the flipping approach.
Don’t give up! Any experienced flipper will tell you that $20,000+ flips don’t come around all too often. The real value from house flipping is in finding underpriced gems and having the resources to boost their value and flip them quickly. An eye for lucrative properties and the quickness to flip them are where the margins happen. And, like any investing modality, it takes time to be proficient in flipping.
Before you invest the money in your first flip, run the numbers and look at what the margins are. What’s the maximum profit you think you can make, and what’s the minimum you need to make for this deal to make sense? Then, factor in taxes. Make sure everything adds up before you go all-in on a flip.