Wholesale real estate purchasing and flipping may seem to be lucrative trade for those outside of the business, particularly when so many seemed to be making thousands in profits selling real estate up until 2008, before the market drop and related recession. However, the wholesale business, in reality, tends to be complicated, profit margins tight, and the wrong steps can result in tax mistakes.There are methods for avoiding taxation on profits made from real estate transactions, but before embarking on any approach, consultation with a licensed tax adviser should always be a first step.
Unlike a traditional real estate transaction, in a wholesale real estate property sale, the profit goal focuses on buying low and selling at a gain quickly without spending anything to improve the property, i.e. it sells "as-is."
Taxation of real estate transactions falls under what the Internal Revenue Service (IRS) categorizes as capital gains. Aside from the exemption provided for one’s first residence, if declared as primary residence ($250,000 of profit for an individual, $500,000 for a couple), profits off a real estate sale are generally taxable under capital gains rates at 25%, according to the IRS. These rates vary depending on how long the capital was held prior to sale.
One approach to avoid capital gains tax when selling a house is to continue to keep labeling a home a primary residence. However, this only works for one residence at a time. Further, an owner needs to hold on to a residence for at least two years to show ownership. The same rule applies to couples filing taxes jointly. As a result, for the purposes of wholesale real estate selling, this approach does not work well. Attempts to use it will likely get one audited and caught trying to evade capital gains taxes.
Alternatively, taking the profits from a real estate transaction and reinvesting them fairly quickly can also avoid taxation. The time window allowed cannot exceed two years from the date of sale. This loophole is due to the fact that the government wants funds put back into real estate as much as possible since it generates significant economic activity by the direct sale and downstream transactions (suppliers, builders, crafters, improvement suppliers, etc.).
The Age Exemption
If you’re over 55, and haven’t done so yet, a single real estate transaction’s profit up to $125,000 can be exempted from taxes. This one-time tax exemption is specific to seniors, and filling out the related information of the sale on Form 2119 is required by the IRS.
Because there are few tax benefits that can be written against capital gains taxes, such as business deductions or credits, the taxes charged tend to take a big bite out of profits gained in a sale. Outside of the exemptions provided above, additional real estate transactions will be taxed accordingly. Due to the way tax laws are written, trying to declare real estate sales profits as business revenue won’t work; the IRS laws require real estate capital gains to be reported separate from business transactions.