Cash Out Tax Question
Hey if we have a property that is being rehabbed and we want to do a non-seasoning cash out refi and then turn it into a rental...is the cash out amount tax free? When we sell in 7-8 years what tax will we owe? Will the original cash out amount be calculated back in?
Thanks
Suntzu18
Borrowed money that must be repaid is not taxable income. Your refi cash out is tax free.
When you sell, your cost basis is determined by what you paid to purchase and improve the property less the depreciation taken (or allowed, whichever is greater) while you held the property. When you subtract your cost basis from your sale price (after selling expenses) you have your taxable profits .
The mortgage loan amount has no affect upon the taxable profit calculation. Your taxable profit will be the same whether the property is owned free and clear or 100% financed.
Newkidintown, thanks for the repsonse. Can I run some sample numbers by you and have you try and break it down for me? If so-thanks a bunch.
House Purchase Price - $101,400
Repairs - $17,000
True ARV - $160,000 (right after repairs)
Selling Price in 8 years (speculating) - $200,000
We want to do a 80% cash out refi and then rent for 8 years.
What will we owe in taxes in 8 years assuming all numbers are correct?
I greatly appreciate your help.
Suntzu18
The previous poster is technically correct that the proceeds from your cashout refi are not taxable BUT, you still have to watch out. If you take the money out of the business then you cannot deduct the interest. Yes, you are only taxed on income and financing cash flows are not income nor are they expenses. When you take out a loan or even when you pay off that loan, those are not taxable events. But, the interest expense you pay on a rental property, for example, are deductible expenses against your rental income. However, like I said, you can't just take the cash out of your business and use it for personal uses. It has to stay in the business. This is what the IRS refers to as "allocating: the interest expense to its use or the "tracing rules".
As to your question about how much tax you'll owe after 8 years, there are a few things to consider.
You basically do this. Establish your cost basis at the onset. THis is what you pay for it plus other costs of acquiring the property. See some IRS publications on this matter and it will spell out for you exactly what should and can't be included in the cost basis.
Then, over the years, you'll depreciate the property to some degree. Keep in mind that you're only depreciating the improvements of the property and not the land since it doesn't depreciate.
Let's say your cost basis is $100,000 and you depreciate it by $20,000 over the term and then sell for $130,000. (keep in mind that similar to when you buy, you have to figure out what to net out of your sales proceeds- Hint: it doesn't have much to do with any loan you may or may not have on the property).
So, what you've got is a gain of $50,000 with $20,000 of it being due to depreciation and $30,000 being due to appreciation. I won't go into it here but the tax you pay on each of these types of gains is different and needs to be accounted for differently.
You'll do yourself a great service if you spend a few hours studying the IRS publication #527. It's the beginner's primer on rental real estate. It will then refer you to several other publications and the tax forms you'll need to complete to account for this and other transactions. If you study that and read a couple other publications then you'll probably be ahead of 1/2 of other "mom and pop" type real estate investors. Being at least familiar with how this stuff works is a great advantage. Even if you do turn your books over to an accountant to do your taxes, having this knowledge with put you in a good position.
Let's make two assumptions:First, you do not make any more capital improvements between now and your saleSecond, the tax codes in effect today which set the capital gains tax rates will not change in the next eight years.
The Purchase Price plus Capital Improvements ($101,400 + $17,000) gives you a cost basis of $118,400.
If you net $200K after selling expenses then your taxable capital gain on this deal due to appreciation will be $81,600. Your long term capital gains tax on this amount will be $16320 (20% capital gains rate).
During your holding period, let's estimate your allowed depreciation at $23,200. Depreciation is recaptured at a 25% rate, for a bill of $5800.
Adding together the long term capital gains tax and the depreciation recapture tax, your total taxes due on the sale of your investment rental property in eight years will be $22,120.
Of course, you can avoid all that tax with a qualified 1031 exchange.