Posted by John Corey on March 23, 2006 at 10:08:35:
Natalie,
I believe you are closer than I was.
The calculation is a bit more complex in that you take the purchase price plus all capital improvements (new roof, etc) minus the depreciation to determine the tax basis. The profit is the difference between the sale price minus closing costs and the tax basis.
Depreciation is taxed at the recapture rate which is not the same as the long term capital gains rate.
Short term capital gains rate is the ordinary income tax rate for the individual (think tax rate on your income from your job).
Even the above is not a full and complete answer.
What is important to me is the following.
Investment property held for 1 plus gets taxed at a different rate and generally a lower rate than investment property held for 1 year or less.
For the fine details I just send it to my accountant they work out the recapture, the tax basis, the long vs. the short term gains and if there are any losses carried over that can be used to offset the possible taxes owed.
You make your money when you buy and get the cash when you sell or refi. Hence I focus on finding the deals and let my accountant advise me on the details for paying the tax. Paying some tax implies I must be winning in that I am showing a profit.
I bought 1 house and 1 duplex in my own name (entity wasn’t done in time) with private money and credit cards. Rehabbed both. Ready to sell now.
House is under contract to sell (pending buyer’s financing). About $20k profit. Super.
Duplex has many tire kickers and a few interested parties, no concrete buyer yet. I have a tenant for each side at a nice rent (this will flow nicely for my buyer). When I sell, I’ll make about $40k profit. Wonderful.
Both properties will be held for about 4 months total unless something happens.
I must sell instead of hold because I?ve partnered on these with someone and to sell was the plan (also, I don?t want to partner with him long term). We?re now talking about holding the duplex as a rental while it?s for sale.
PROBLEM: Partner & TAXES.
Partner
a. I don?t want to partner with him more than to just fix and flip (not long term, not rental).
b. Do I 1099 him so HE can pay HIS share of taxes? I?m the only one on all paperwork.
Taxes
a. How can I minimize my tax hit if I?m holding
Cash out refi does nothing. Taxes depend on your basis. Basis is how much the place costs you to pick up. Say you bought the place for $200k at 70% of value. That means the house is really worth $285k. Let’s say you see 5% appreciation over 6 months during the year, that’s another $15k. You sell before the end of the year … your basis is your original cost ($200k), subtract that from your sale price ($300k) and you are left with $100k profit.
When you do a cash refi, you need to look at your balance sheet. Assume you bought the $200k house with $100k cash and $100k loan.
Before Refi …
Assets: $300k ($300k house + $0k cash)
Liabilities: $100k
Net Balance: $200k
After Refi …
Assets: $500k ($300k house + $200k cash)
Liabilities: $300k ($100k loan + $200k refi)
Net Balance: $200k
Your net balance doesn’t change, it’s just a transfer of assets from one form (real estate equity) into another form (cash). You made your real money when you bought the house at a $100k discount … and it will show up on the paperwork when you sell the house.
Re: How to avoid a jumbo tax hit with fix n flips? - Posted by John Corey
Posted by John Corey on March 22, 2006 at 05:22:45:
Rob,
If you sell in under a year you will have ordinary income taxes to pay as you suspected. You can not refi and then sell to reduce the gain as the sale will trigger the taxes on your profit and not the equity. The other person was largely incorrect.
I am not sure 1099 is the right way to document that interest the other person has in the property. Without looking into the details it might be just fine. Or you can record an option or some other charge that is settled at closing so that on the HUD1 you have a payment to the other person. It will be ordinary income so not much need to worry about how the income shows. Just that there is clear documentation.
Your partnership structure is suspect but I suspect you know that.
1031 exchanges are for property held as an investment. The properties were not held for investment so no 1031 possibilities. If you held for a tax year or more as a rental then things would be different.
Consider two models. Some entity that is optimized for current income to hold property that will be flipped. A different entity or structure for property that will be held as a rental. With the first you buy and sell but run expenses such as medical, life insurance, car, pension through that entity. Keep it clean, legal and focus on the overall success with that vehicle. If you show losses you will have issues getting credit so reduce the taxes but do not focus on zero taxes. Expect this vehicle might end up with IRS dealer status from the buy and sell activities.
With the second entity you can operate with a buy and hold strategy. Exit with a 1031 or long term capital gains tax. Legal protection is important here but the tax efficiency comes from a long term hold and not lots of legal deductions associated with the entity.
Go to the legal form or pick up some reading materials that highlight the differences. It could be a C corp or other structure for the 1st vehicle and a LLC or similar for the second. Sharper minds will be able to advise.
One way to work a partner deal is with options. Barney Zick’s materials covers such things. Partner remains silent, has vested stack, is clearly protected without being a co-manager of the project.
Capital gains or income tax? - Posted by rick in erie
Posted by rick in erie on March 22, 2006 at 21:58:27:
Thanks for that post. I buy and hold, and also do flips, and hopefully soon, setting up an entity to pay for medical insurance, etc. will be important (hope to retire from job within 2 years) My question is you say ordinary tax on the flip, do you mean cap gain, or income tax? I am just finishing my first flip (about 25k profit) and believed the profit would be cap gain tax, not the higher income tax. Thanks in advance. Rick
Yeah, the partnership on this is messed up (I’m feeling it more and more each day). But the reason I did it like this was that he owed me $ from a previous loan that fell through. The only way I felt I could get any money from one who has nothing but tons of real estate deals and a heckuvuh network was to get a few houses in my name and do a few deals with him. He gets screamin? deals; many, cheap and often!
What I should’ve done is just offered an assignment fee for contract(s). He might have vanished though and I?d be slower to recoup my losses (probably not from him). In my excitement, I wound up in a partnership (for 2 deals). Since I put up the $, I put the place in my name and then did a little partnership agreement saying that we’d buy, fix and sell. The proceeds would be divided as follows:
Reimburse the costs associated with the deal, firstly, any private lenders.
Divide up the remaining funds btwn partner and me (50/50).
From my partner?s portion would come payment for any pre-existing debt owed to me (a little Hx here).
That Hx is the only reason I?m doing this partnership with him is to get paid back. Also, I can?t find as good or as many deals as quickly as he does yet, so this seemed like the quickest way to get repaid.
I?ve got to get a good partnership agreement though; although I hope I don?t need to partner anymore after these few.
Any tips or suggestions would be greatly appreciated.
Re: Capital gains or income tax? - Posted by John Corey
Posted by John Corey on March 23, 2006 at 05:16:11:
Rick,
Capital gains happens when you show a profit on an investment that you have owned over a year (366 days). If you sell the investment before the 1 year and a day mark you will be paying ordinary income tax. This is what you are calling income tax. Note that ‘income tax’ is tax on income (both capital income tax and ordinary income tax).
If you own a property for over a year and you have depreciation then you will have recapture on that depreciation so there is more to it than just ordinary tax rates and capital gain tax rates.
I am suggesting professional advice when it comes time to worry about the fine details. Assume that the vehicle that will generate short term profits (under a year) is likely the best vehicle to be paying for medical and other such expenses. Also note that the corporate tax rate can be lower on the first $100K than the personal tax rates depending on a number of factors. Hence it might be cheaper just to show the taxes as profits from the company.
Before getting too caught up in the tax aspects consider some other factors.
Liability protection and the use of entities plus insurance to firewall the liability.
Ability to obtain financing. If you are showing no profits or no taxable income you or the company may have problems obtaining financing. Hence to zero out the tax liability might mean severe restrictions on your financing opportunities.
Focus on doing profitable deals and accept that paying taxes is one possible way to keep score. Someone has to pay for the roads and the fire department. Hence some amount of tax is OK. If you are showing that you pay taxes you are saying you made money. Maybe simple but actually how lenders and others tend to see things.
No one that I know of has ever said not to a raise when they had a job. They figured that part of the raise in their pocket was better than no raise. Let the hunt for profits drive the decisions. Be smart about how to organize your tax liability while recognizing that the tax bill is a secondary factor.
Re: Capital gains or income tax? - Posted by Natalie-VA
Posted by Natalie-VA on March 23, 2006 at 08:08:49:
John,
Great job helping the poster, but I want to clarify something:
A capital gain is the difference between what you paid for an investment and what you received when you sold that investment.
It has nothing to do with how long you held the investment. It’s still a capital gain. The difference comes in with the tax rate that you pay if you hold it over a year or less than a year. Capitial gains rates on assets held less than one year are taxed at ordinary income rates, yes?