Private Investor Tax Implications
I have an investor who has offered to give me 15% of net profit after a deal closes if I fund the purchase.
What would my tax implications be if say I funded a $20,000 purchase and the sell ended up netting him $10,000, which in turn would net me $1,500 in profit. What would I be taxed on? I plan on doing this in a LLC if I decide to pursue it.
Any advice is greatly appreciated.
I believe it would be taxed as ordinary income so it depends on your tax bracket. Are you putting up all the money in exchange for 15% of the profits? If that's the case you seem to be getting the short end of the stick. An investor putting up all the money can usually negotiate a much higher percentage than that since he/she is taking on all the risk.
@Steve Buchanan being that this is a investment, this wouldn't be capital gains?
I am funding the purchase price. The property is being sold as-is and there is very little risk involved because it's a wholesale deal and there is hardly any renovation being done. $1,500 profit on a $20,000 investment in a month or even two months is a great return if you annualized it. Wouldn't you agree?
Its ordinary income, not capital gains. Capital gains would be, for example, from the sale of a rental. Income from a loan to a rehabber is ordinary income. Income from doing a rehab project is ordinary income.
Be sure you truly understand this deal. This sounds too good to be true. That's always a BIG red flag for me. Be sure this property is a good deal for a purchase price of $20K. Because you may well end up owning it. Also be sure you're the documented lender. Either on the title or (better, IMHO) as the grantee on a deed of trust or mortgage giving you a security interest in the property.
The profits will be taxed as short-term capital gains which are taxed at your ordinary income rate. To be considered a long-term capital gain, you would need to hold the asset (a note in this case) for more than one year. At that point you would be taxed at 0, 15 or 20% depending on your income levels.
And I agree with @Steve Buchanan in that if you are putting up all the money, you should have a much higher payout. You are the one taking all the risk and should be compensated as such.
So I have two people @Steve Buchanan and @Brandon Hall saying I should get a much higher payout, and then I have another reputable member of BP: @Jon Holdman telling me this deal may be too good to be true.
Now I'm really confused. Steve, and Brandon, did you calculate the annualized return on that deal? I'm having trouble understanding how earning 7.5% in one month is not a great payout? Even in two months it's still a good payout.
I should mention that I am the one that found the deal and have done my due diligence with all of my network. This investor is paying me in the form of an assignment fee on the front and giving me the opportunity to make money on the back by being a private investor. Whether or not I invest he is still purchasing the deal and paying me my assignment fee that we agreed upon.
I believe when @Jon Holdman said the deal is too good to be true he was referring to being able to buy the property for 20K, put near nothing into renovations, and then resell it at a 10k profit. I do not think he was referring to your deal with your partner to put up all the money for 15% as the part that was too good to be true.
@Steve Buchanan has it right. Buying a place for $20K, doing "hardly any renovation", and selling very quickly at a 50% increase in value is the part that seems too good to be true.
Further, investing $20K for two months and earning $1.5K is indeed a 7.5% return. Annualized, though, is 45%. That puts it also into the too good to be true category.
OTOH, when @Brandon Hall says you're taking all the risk, I agree. From what you write, the guy buying the house really isn't doing anything. Its essentially a wholesale transaction and you are essentially a transactional funder. Transactional funders typically don't let the money out for two months. Its a day, or a few days at the most. And they make very sure the end buyer is going to close before they fund the initial loan. Maybe there's more going on here that makes this OK.
So, my advice remains. Be sure you have a path to taking the property if the deal falls apart and be sure you are comfortable with paying $20K for this property.
Oh, and always best to discuss the details with your accountant to get a correct answer to your tax question. Or at least one your accountant is willing to defend to the IRS.
@Jon Holdman I agree a 50% increase is too good to be true, but with that said, he is confident he can sell it for $3,000- $5,000 more without having to do anything to the property. Maybe clean it up, but that's it. After doing my due diligence this seems realistic.
I also agree that it's basically transactional funding, but in this case it's going to take longer.
I agree that he's having to do very little, but on the other hand he has invested a lot of time and money into building his buyers list which is one reason he's able to sell it for that price.
Will it cost me money to have me as the documented lender on a deed of trust or mortgage? Is it standard for him to pay for these fees to have this done?
Will it cost me money to have me as the documented lender on a deed of trust or mortgage? Is it standard for him to pay for these fees to have this done?
Yes, it will. The mortgage or deed of trust (whichever is used in your state) will have to be prepared. You will also want a promissory note. The title company may have templates, but even if you find some you probably want to review them by your attorney. You're creating a mortgage. You want to same documentation as any lender.
Typically the borrower will pay recording fees. But not the fees to create the documents. This may seems expensive, but presumably you will do this again some day. If things go bad, and I've made loans where they did, these documents are your protection.