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Tax implications of long-term rental properties vs. flipping


Let's break down the tax treatment for both rental income and flipping properties, as they are distinct aspects of real estate investing and are treated differently by the IRS.

Rental Income: Passive Income

When you earn money from renting out a property, it's considered passive income. Here's how the tax treatment works:

  1. Taxable Income: Rental income is taxed as ordinary income. This means that the money you earn from renting out a property is added to your other income sources and taxed at your marginal tax rate.

  2. Deductible Expenses: The good news is that property owners can deduct many expenses associated with the rental property. Common deductions include mortgage interest, property tax, operating expenses, depreciation, and repairs. By deducting these expenses, property owners can often significantly reduce the taxable income generated by the property.

  3. Depreciation: This is a non-cash expense that allows property owners to write off a portion of the property's value each year. Over time, this can significantly reduce your taxable income, even though it's not a direct out-of-pocket expense.

Flipping Properties: Active Income

Flipping involves buying properties, making improvements, and then selling them for a profit. It's considered more of an active business, and here's how its tax treatment works:

  1. Ordinary Income: Profits from flipping properties are generally considered ordinary income, not capital gains. This means the profit is added to your other income and taxed at your regular tax rate, which could be higher than the long-term capital gains rate.

  2. Self-Employment Tax: If you're in the business of flipping properties, you're essentially running a business. This means you might be subject to self-employment tax (Medicare and Social Security) on your profits.

  3. Holding Period Matters: If you hold the flipped property for less than a year, any profit will be considered short-term capital gain, taxed at your ordinary income tax rate. However, if you hold it for more than a year (which is rare in flipping), the profit might be taxed at the more favorable long-term capital gains rate.

  4. Deductible Business Expenses: Flippers can deduct business expenses related to the flip. This includes costs like materials, contractor fees, and more. However, these deductions work a bit differently than the rental property deductions.

Key Differences:

  1. Nature of Income: Rental properties generate passive income, while flipping properties is an active business endeavor.

  2. Rate of Taxation: Rental income is taxed at your ordinary tax rate after accounting for deductions. Flipping, if done frequently, can lead to higher taxation since it's seen as business income.

  3. Deductions: Both rental and flipping ventures have associated expenses that can be deducted, but the nature and application of these deductions vary.

When deciding between renting out properties or flipping them, it's essential to understand these tax implications. Each approach has its advantages and challenges, and the best choice often depends on your financial goals, skills, and risk tolerance. Always consult with a tax professional to understand the nuances and to plan your strategy effectively.

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