Capital Gains On My First Rehab
Good morning all and happy investing
My question: I just purchased my first rehab project which I intend on L/O in the next few months here is what I have so far
40,000 purchase
5-10k rehab budget
70-75k comps
I intend to sell on a 24 month L/O for 78-82k
After I am done with the rehab I am going to refi on a 5% interest only heloc for 90% or about 68000 to pay off intial finance and rehab costs. leaving me about 18,000 to reinvest in my next rehab. I will most likely get $2500 on my option and perhaps $10000 on the back end at time of sale after paying off my heloc. My question is: on what portions of the proceeds will I pay capital gains tax? All of the sale price? profit before paying off my heloc? I am not clear on what I am liable for and how I should be pulling out my equity as to minimize liability.
Many thanks,
Bri
You will only realize capital gains when you sell the property. Anythng that is financed is not subject to tax as you actually borrowed the money and are paying interest on it.
but what is taxed sale price or profit and depreciation after paying back the loans?
The IRS considers rehabbing an active trade or business and normally is subject to self employment tax in an LLC or own name. However, since you plan to rent the property out tax will be figured upon the gain of the property minus depreciation that is recaputed.
Now, do we figure capital gains based on your purchase price or after rehab price? For this, we have do deal with something called basis. When doing your work anything that is considered a capital improvement (New A/C, kitchen, etc) steps us basis. Things like tools, paint, board to cover broken windows, etc are expenses and can be deducted normally. If your old value was $75,000 and you put $15,000 to fix it up, probably $13000-14000 would be added to basis.
If you buy for $75,000 and you add $14,000 in capital improvements your new basis to figure capital gains tax from is $89,000.
For simplistic purposes and the advantages/disadvantages of an LLC vs. S-Corp for various activities might consider setting up an S-Corp for rehab and it would sell it to your LLC to hold. Much simpler in my opinion. Trying to deal with a steped-up basis can become very expensive and complicated.
GOOD LUCK[ Edited by DaveT on Date 11/22/2003 ]
Quote:I am not clear on what I am liable for and how I should be pulling out my equity as to minimize liability.Brill,
Pulling equity out of your property (as in a refinance) is a non-taxable event and is transparent to the IRS. Your total profit is what is taxed, not the difference between your sale price and your mortgage balance.
I know that you asked about selling your rehab property on a lease-option and myfrogger's response may seem confusing.
Let's clarify. Your pattern of activity -- rehab, sell on L/O, purchase new property -- is an active income activity. You are just using the L/O as a delayed sale to disguise your flip activity.
This pattern of activity may lead the IRS to characterize each of your transactions as an active income activity and disqualify any 1031 exchanges involving these properties.
Consult a licensed tax professional in your area for specific details.
Thanks much for the replies. I always learn alot here. And Dave I'm not trying to disguise the sale of this property. I just thought it would be easier getting Tenant buyers than tenants. If I find that I can rent this out easily I may and I am not wanting to just flip properties
Iwant to build a strong portfolio but need some capital to work with. I believe that rehabing a few properties a year may help. As for the tax issues, I am at a total loss and need to spend some time in this forum and with an accountant so as not to get myself into trobule early.
Many thanks all
Bri
Quote:And Dave I'm not trying to disguise the sale of this property. I just thought it would be easier getting Tenant buyers than tenants.Brill,
Sorry I came on a little strong here. I certainly was not accusing you of anything wrong. Instead, I am giving you a heads up to how the IRS will treat the pattern of activity embodied in your rehab-sell on L/O strategy.
Remember that what we may consider an investment in real estate is not always investment property in the eyes of the IRS. Sometimes, it is dealer realty and that is how I see the IRS viewing your approach.
Thanks Dave. So in your opinion, will L/O perhaps eat up a large portion of my profit via tax liability? I may have to rethink my plan. I would like to perserve as much of the profit possible this early in my REI career due to lack of working capital.
Taxes are somthing I really haven't thought that much into thus far. I assumed I would learn when I had to, but preemting problems would be a big plus..
If you want quick cash from each deal, then you will have higher income tax consequences from your active income activities. Work through some numbers on paper. Consider the property cost, the rehab cost, the holding cost, and the sale price. Now, after subtracting all your costs from your sale price, how much is your profit? If you are in the 25% tax bracket, then you should have better than 60% of your profit left after self-employment taxes. Do one of these each year.
If you want to build wealth more slowly, then you have to hold your property for the production of income and appreciation. This allows you to take the more tax advantaged capital gains tax treatment. Consider your purchase price, your rehab costs, and your sale price after you have used the property as a rental for a couple of years. Now calculate your profits and give the IRS 15%. Oh, and if you made any cash flow on the rental along the way, that is just more icing on the cake. At the end of two years is your rental income and after tax sale profit at least as much as you have after doing two flips?
Either way, remember that no one ever went broke taking a profit.
You may want to visit the Tax Reduction Institute website at ****Must Reach Freshman Investor status before posting URL's***
I took a course called Tax and Financial Strategies for Residential Real Estate. It was a great course and I go back to the book often. The course teaches the difference between how a property is taxed (gains vs self employment), gives formulas for figuring out your basis for sale etc. You can count just about everything! Mileage to look for the property, and milage costs to go and work there, inspections you paid for, closing costs you paid to help the buyer purchase etc. I couldn't possibly tell you everything that is in this course. I found it to be an invaluable tool. It wasn't cheap but heh, it was tax deductible as a business expense! They also have tips and monthly newsletters if you want them. Check it out.