I deal with a lot of house flippers and even rental owners who are doing their math the wrong way. It ends up with them paying less taxes at first, but eventually they pay more than they otherwise would. It also causes more work for them on the bookkeeping side of things!
Let’s look at the wrong way, the problem that causes, then how to do flip math the right way. I’ll approach it from a house flipping perspective.
The wrong way
Let’s say you have a flip house you know is going to sell. But it won’t sell this year. It will sell in a year or two. But all of your work is being done this year.
You may be tempted to think, “I’m doing all this work and it’s costing money, so that’s an expense. So I’ll take all my repairs, utilities, everything else, and record it as an expense on my profit and loss. That will help me reduce my tax liability this year.”
And you’re right! It will help you reduce your tax liability that first year. But that’s not how it should work at all.
If you claim all that as expenses, the first year you actually end up with a tax credit. But the second year, when all of the cash comes in, you’ll probably pay off a loan or credit card you used to finance the renovation.
Then at the end of that year, you owe an aggressive amount of money for what you’re actually spending on the flip house! Not only are you making your taxes lopsided, but you’re quickly going to lose the ability to budget the flip over time. That means you’re making more work for yourself on the bookkeeping side of things!
The right way
Instead, take those “expenses” and call them what they really are. In accounting we call them costs. Costs get recorded as assets against the property.
When you’re buying a flip house, you’re also buying the flip costs. In accounting we call those capitol expenditures, or capex for short. So your rehab costs are really capex, and instead of claiming it as an expense you claim it as an asset.
Later, when you sell your asset, you can move it into the cost of goods sold. And that’s the right way to do it!
Then money you’re actually spending and making are the same, but you end up sharing the tax burden across a couple of years and making your bookkeeping work much more simple to do. The other way just isn’t worth it in the long term.