Understanding The Difference Between Real Estate Flipping And Investing

Real estate offers numerous opportunities for generating income and building wealth. Two popular strategies are real estate investing and property flipping.

While they might seem similar, they cater to different objectives and have distinct advantages and disadvantages. Understanding these differences is crucial for making informed decisions that align with your financial goals.

“Investing is for someone with a long-term objective, which means at least five years, but can be 10, 20, 30 or more years,” said Jeff Richer, SCORE mentor and real estate investor. “Investors purchase properties to own and manage over time, generating income and benefiting from property appreciation.”

1. Rental Income: As a landlord, you collect rent from tenants, providing a steady business income stream.
2. Appreciation: Real estate properties generally increase in value over time. This appreciation becomes a significant profit when you decide to sell.
3. Tax Benefits: Investors can reduce their taxable income through depreciation, a non-cash expense that reflects the property’s wear and tear over time.

• Annual Taxes: You’ll pay taxes on your net rental income, which is your rental income minus allowable business expenses like property taxes, insurance, repairs, and utilities.
• Depreciation: Depreciation can significantly lower your taxable income, deferring tax liability until the property is sold.
• Capital Gains Tax: When you sell the property, you’ll pay capital gains tax on the appreciation. Long-term capital gains taxes are often lower than ordinary income tax rates.

“You typically annually will only pay taxes on the income received minus all your business expenses (e.g., property taxes, insurance, repairs needed and utility bills),” said Richer. “So, whatever tax bracket you are in, this income would be taxed at that rate each year. If you were in the 25% tax bracket and you had an income each year of $4,000, you’d only pay $1,000 in taxes.”

• Passive Income: Rental income can provide a steady, passive income stream.
• Wealth Accumulation: Holding properties long-term allows you to build substantial wealth through appreciation.
• Tax Efficiency: Depreciation and other tax deductions can reduce your annual tax burden.

Flipping involves purchasing properties, often needing significant repairs, renovating them, and selling them quickly for a profit. This strategy is short-term and usually completed within a few months.

• Profit from Sale: The primary income is the difference between the property’s selling price and the total costs incurred, including purchase price, renovation expenses, and holding costs.

• Short-Term Capital Gains Tax: Profits from flipping are considered short-term capital gains and are taxed as ordinary income, which can be a higher rate than long-term capital gains.
• Additional Costs: Flippers must account for various taxes and fees, such as: State and Local Taxes: These can include state income tax and local transfer taxes.Business Taxes and Permits: Necessary for legal compliance during renovations.Real Estate Agent Commissions: Typically around 6% of the selling price.Closing Costs: Additional fees associated with the sale process.

“If you’d own the property for eight months and sold it for an $85,000 profit, the taxes you would have to pay are totally different,” said Richer. “This would be taxed as a short-term profit, or likely 30% or more in federal taxes, then about 3% to the state, plus the business taxes, fees, and permits. You would also have to pay transfer taxes of about 8% (between buying and selling the property). Finally, that realtor’s fee might be 6% when you sell it.”

“So, someone would pay about 50% of $85,000, or $42,500 would be paid in taxes. That’s a huge difference, and many flippers don’t even consider it until taxes need to be filed each year.”

• Quick Returns: Potential for a substantial profit in a short period.
• Active Involvement: Requires significant time, effort, and expertise in property renovations.
• Higher Tax Liability: A larger portion of profits may go toward taxes compared to long-term investing.

Before diving into real estate flipping or investing, consider the following:

• Financial Goals: Are you looking for immediate income or long-term wealth accumulation?
• Time Commitment: Do you prefer a passive income stream, or are you willing to actively participate in property management or renovations?
• Risk Tolerance: Flipping can be riskier due to market fluctuations and unexpected renovation costs.
• Tax Considerations: Understand the tax implications of each strategy to maximize your after-tax income.

Real estate flipping and investing offer different paths to making money in the property market. Investing is geared toward long-term wealth creation with ongoing income and tax advantages while flipping focuses on short-term profits with higher active involvement and tax liabilities.

“Taxes will be part of this equation,” said Richer. “So, what you do is your decision, but please go into it with your eyes open and know what you are getting yourself into before you make that decision.”

Consulting with real estate professionals, tax advisors and SCORE mentors can provide valuable insights tailored to you.

This article originally appeared on SCORE.