Borrow equity to avoid capital gains tax?

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Borrow equity to avoid capital gains tax?

Nicole S.
Investor · Seattle, WA · Member since 2015 · 195 posts · 101 votes

Good Morning BP, 

I've been searching the forums in hopes of my answer but no luck, yet. 

This is my loose understanding: I was told by some investors this weekend I could borrow the equity in my investment property to avoid capital gains tax because there would be "no gain". The property is currently in contract right now and we're set to close on July 11. Has anyone heard of this strategy? 

Purchase Price: $146,950

Sales Price: $215,000

Mortgage Debt: $107,000

Borrow: ~$108,000

I was told that we need to record the borrowed amount with the sale. Who is going to loan me 100% equity?! Certainly not a mainstream bank - does that mean I'm looking at private money? I'd certainly rather pay those rates than the IRS capital gains rate! 

Thanks in advance. I really appreciate any insight. 

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
10y

@Nicole S., You can certainly access spending money by borrowing against a property  but borrowing money from equity does not relieve you from recognizing gain.  It only creates liquidity and effects the amount you have to pay back.  

There's two issues you ought to think about.

1. If you borrow money now on a property you're closing on soon you'll have all sorts of costs, originations, etc.  And you'll only have the money to spend for a short time since it will have to satisfy the loan when you close the sale.  And of course the big issue - It does not change your taxable gain situation.

2. The way to avoid paying tax is with a 1031 exchange where you sell an appreciated property and use the proceeds to buy another or more than one new investment properties.  In your example you're selling for 215K and you'll have about 107K in cash proceeds and a gain of around 69K.  In order to defer all of that 20K or so of taxes you would need to do a 1031 and purchase at least 215K of real estate (one or more properties) and use all 107K to do so.  If you wanted to take some cash out you can but anything you do not reinvest or any amount you buy down you pay tax on the difference.

I think what your investor friends were thinking of sort of was the fact that  once your 1031 is complete it is perfectly fine to refinance at that point to access liquid cash.  Again this loan does nothing to change your gain situation as you move forward but it is nontaxable at that point as all the gain is deferred in the new properties.

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    10y

    @Nicole S., You can certainly access spending money by borrowing against a property  but borrowing money from equity does not relieve you from recognizing gain.  It only creates liquidity and effects the amount you have to pay back.  

    There's two issues you ought to think about.

    1. If you borrow money now on a property you're closing on soon you'll have all sorts of costs, originations, etc.  And you'll only have the money to spend for a short time since it will have to satisfy the loan when you close the sale.  And of course the big issue - It does not change your taxable gain situation.

    2. The way to avoid paying tax is with a 1031 exchange where you sell an appreciated property and use the proceeds to buy another or more than one new investment properties.  In your example you're selling for 215K and you'll have about 107K in cash proceeds and a gain of around 69K.  In order to defer all of that 20K or so of taxes you would need to do a 1031 and purchase at least 215K of real estate (one or more properties) and use all 107K to do so.  If you wanted to take some cash out you can but anything you do not reinvest or any amount you buy down you pay tax on the difference.

    I think what your investor friends were thinking of sort of was the fact that  once your 1031 is complete it is perfectly fine to refinance at that point to access liquid cash.  Again this loan does nothing to change your gain situation as you move forward but it is nontaxable at that point as all the gain is deferred in the new properties.

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  • Nicole S.
    OP
    Investor · Seattle, WA · Member since 2015 · 195 posts · 101 votes
    10y

    Thank you @Dave Foster !!

    I've been reading your posts in the forums and you're brilliant! I really appreciate your answer. 

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  • Nicole S.
    OP
    Investor · Seattle, WA · Member since 2015 · 195 posts · 101 votes
    10y

    @Dave Foster

    I found out what the capital gains tax deferral strategy is and who it came from. A local real estate investor in Washington state and owner of real estate seminar "Reach Returns" Greg Pinneo. He now owns the Cor Company and if you do a little research, you'll find he pleaded guilty to bank fraud and served a prison sentence for it in the late 90's. 

    In order to defer capital gains, he advises folks to purchase property via seller financing without a "due on sale clause". As the buyer he negotiates the financing terms with the seller. That way, when he sells the property he doesn't have to cash out the underlying note. When he sells the property to a buyer he uses seller financing again but the length of this loan is due just shy of the original underlying note that he owes to the original seller. The loans are for the same amount. He makes money on the deal by charging more in interest than what he pays on the original note and he pockets some of the cash from the down payment. He claims his real estate strategy is playing bank, not sure how well that's working for him these days though, I'm not sure how old this advice is or if it's viable. 

    If you're curious I can share the white papers he wrote on this that I found on the Internet. 

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    10y

    @Nicole S. Thanks for sharing that with me. Bummer of a footnote on him.  The first thing that screams out at me is that at the very minimum he would be deferring capital gains by trading that for ordinary income tax.  That doesn't seem smart unless pocketing really meant pocketing!  I sense all kinds of trouble legally.  and it hurts my head to even think of the right way to structure such a deal to remain in compliance with a dozen different regulatory laws.  

    @Jay Hinrichs, @Brandon Hall, @Account Closed, you guys out there?  This one is interesting.  What does the wizened experienced brain trust have to say?

    As I shared in a class today.  The difference between tax avoidance and tax evasion is sometimes just which side of the door the lock is on.

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  • Brian Gibbons
    Investor · Sherman Oaks, CA · Member since 2008 · 6k+ posts · 3k+ votes
    10y
    Originally posted by @Nicole S.:

    Thank you @Dave Foster !!

    I've been reading your posts in the forums and you're brilliant! I really appreciate your answer. 

      Nicole the term QI Or qualified intermediary for a 1031 or reverse 1031 is not an easy qualification to earn

    I appreciate all your posts Dave!

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  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    10y

    @Nicole S.  nothing new your talking about AIDT  that we did in CA in the 70s and 80s..

    My dad had a company called California WRAP  pre internet mind you.

    and yes you can buy a property for X and put a loan on it for Y that is greater than X and the difference is not taxed at that time.. But YOUR BASIS goes up and when you sell you pay tax at that time.

    still a little foggy on exactly what they are preaching..

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  • Rodriguez VictorPro Member
    Eagle Pass, TX · Member since 2016 · 17 posts · 5 votes
    10y

    good read 

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  • Nicole S.
    OP
    Investor · Seattle, WA · Member since 2015 · 195 posts · 101 votes
    10y

    thanks @Jay 

    The papers I read were indeed vague. I'm sure that's by design considering the cost of this guy's upcoming seminar. Sounds like you recognize it though. This is the first time I've sold an investment property so this is all new to me...just like the 80s! ;-) I figured I'd find expert advice from the BP community. Thanks!!! 

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  • Ned CareyPro Member
    Moderator
    Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes
    10y

    @Dave Foster@Nicole S.,  @Dave Foster explained it well. I will put it in simpler terms. The strategy proposed is absolutely bogus. Loan on a property have nothing to do with your basis or gain.

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  • Nicole S.
    OP
    Investor · Seattle, WA · Member since 2015 · 195 posts · 101 votes
    10y

    @Ned, bogus is right! I thought it was too good to be true but I had to check with the BP experts! 

    Not sure why my tags aren't working...maybe it's because I'm using a tablet. 

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  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    10y
    Originally posted by @Nicole S.:

    @Ned, bogus is right! I thought it was too good to be true but I had to check with the BP experts! 

    Not sure why my tags aren't working...maybe it's because I'm using a tablet. 

     Talking about the 80's makes me think you've been around the block, but where is your BS Meter? Seems you're seeking advice in all the wrong places. That's two for two!

    Your note clown is stepping into RICO laws, probably fraud to "sell", with predatory lending practices. Your friends the investors are poking at tax fraud trying to hide gains.

    Prisons are full of smart people, wise guy types. 

    Seek better advisers. :)  

    2Reply
  • John D.
    Rental Property Investor · La Quinta, CA · Member since 2014 · 1k+ posts · 779 votes
    10y

    @Nicole S. I suspect the actual intent was to hide the taxable gain, by artificially increasing the sales price via an "insider loan" or cash payment which is funneled back to the seller.  Leaving the cash purchase price to the buyer the same, but effectively obfuscating the gain to the seller in the eyes of the IRS.  Steer clear.

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  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    10y

    @Ned Carey@Nicole S.  Ned I need to correct my response I met to say the higher loan amount does NOT increase your basis.. so when you sell you will pay tax on the original purchase price not the new note amount.  Where I think ( and its a little hard to track )

    what the premise is that a cash out refi above basis is tax tree and you never pay tax on that gain of cash .. which is not true.. you don't pay at the time of the refi you pay when you sell.

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  • Robert White
    Investor · Endicott, NY · Member since 2015 · 34 posts · 36 votes
    10y

    Isn't he the same guy who wrote "Millionaire Secrets to Getting Free Room and Board from the Government"?

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  • Ned CareyPro Member
    Moderator
    Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes
    10y

    @Jay Hinrichs I wasn't questioning anything you said.  

    I just wasn't smart enough to understand it LOL

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    10y
    Originally posted by @Robert White:

    Isn't he the same guy who wrote "Millionaire Secrets to Getting Free Room and Board from the Government"?

     If it is, then the BS Meter is turned off!

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  • Nicole S.
    OP
    Investor · Seattle, WA · Member since 2015 · 195 posts · 101 votes
    10y

    @Robert White  I have no idea if he wrote "Millionaire Secrets..." A quick Internet search came up with nothing...

    @Bill Gulley  I would argue that my BS meter was on and functioning well when this strategy came across my desk! LOL 

    @John D.  I think you hit the nail on the head. I copied the example he uses in his white paper below. 

    Below, if anyone is interested, I've copied the example Greg Pinneo uses in his white paper I found on the Internet. I believe this is how he claims to defer or exempt himself from paying capital gains at the time of sale. You'd have to read the paper yourself and draw your own conclusions, it's vaguely written. 

    Take for example a building that I recently purchased for $1,150,000. I put $50,000.

    down, and the balance was in the form of a promissory note where by the seller was the

    beneficiary. The interest rate on the note is 5.5%, payments are interest only or more,

    and all outstanding principle is due the beneficiary twenty years from closing.

    If the underlying note of $1,100,000. were bank financed, and I wanted or needed to

    sell, I would need to attract a buyer who was willing to get all new financing through

    some means, or write a very big check at closing. However, in that the underlying is a

    private note, and the note has no due on sale clause, I can sell the property without

    cashing out the underlying.

    For example, if I sold the property for $1,300,000. I could create the following terms

    for my buyer. Purchase price is $1,300,000. Down payment is $200,000. (out of this

    down payment, I re-capitalize my $50,000. that I put down, pay my $30,000. closing

    costs as a seller, and walk out of escrow with $120,000. left over). Then, I would be the

    beneficiary of a note in the amount of $1,100,000. The rate I would charge the buyer is

    7.5%. They would pay me INTEREST ONLY with the full principle due me

    approximately six months before my underlying is due. (approximately 19.5 years from

    closing) My note would be collateralized by an all inclusive trust deed on the subject

    property. The difference of the interest rates, what I negotiated on the buy, and what I

    offered on the sale is 2%. This difference amounts to $1,833. per month for 19.5 years.

    Over time, not compounding the intake of capitol or the principle difference that I was

    paid at closing; just this margin difference is in excess of $428,000.00.

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  • Account Closed
    Writer | Attorney | Accountant · Dallas, TX · Member since 2016 · 150 posts · 116 votes
    10y

    This is not complicated.  It's called Wraparound Financing and it has been going on since the early 80's.  I've done hundreds of these for clients.  If he bought the property for $1,150,000  and he sold it for $1,300,000 he has a gross profit of $150,000.  He deducts his transaction costs of $30,000 and he has a net profit of $120,000.  This is his capital gains.  If he held the property for a year or less, this $120,000 will be Short Term Capital Gains and taxed at his ordinary income marginal tax rate.  If he held the property for more than a year, the $120,000 will be taxed at whatever his Long Term Capital Gains Tax Rate is, determined by his Adjusted Gross Income.  He sold the property on an Installment Sale, so the Installment Sale Rules apply, and those Rules say that the capital gains is taxable as he receives it with each payment.  But for the first year of the installment sale, the down payment is included with the first series of monthly payments.  And since he received $200,000 down payment, the entire $120,000 is taxable as capital gains at the end of the tax year in which the sale took place.  The payments he receives will be interest and will be taxed as Interest Income, reported on Schedule B as "Seller Financed Mortgage" and included in his other income on Form 1040.  The only way to avoid paying the capital gains tax under this scenario is to not report the Down Payment on Form 6252 Installment Sale Income, and that would be Tax Evasion.  Not a good idea.

    By the way, he says he would only report the $1,833 monthly difference between what he is receiving from his Buyer and what he is paying to his Seller.  This is incorrect.  He would be required to report the entire $6,875.00 monthly payment as interest income on Schedule B.  The $5,041.67 monthly payment that he is paying on his note must be claimed on his Schedule A Itemized Deductions as "investment interest expense."  But this deduction is only available while he is holding the investment property for income or for appreciation, and ceased when he sold it.  So, it looks like he stepped in that one, too.

    Conclusion:  he will pay capital gains tax on the $120,000 in the year of sale; he will report $82,500 of annual interest income; and he will get no benefit from the $60,572.04 portion that he sends to the original owner.

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    10y

    2016 there are new asset allocation rules for installment sales and options, the depreciation over the 20 years goes to the new buyer, Greg gets to pay taxes on his installment sale even if he doesn't receive principal, you don't defer taxes for 20 years. See your CPA!

    This is a  "Subject-to" transaction, hopefully using two notes.

    A seller is willing to take I/O for 20 years is probably 1 in a thousand and they will be taxed just as Greg is, make that 1 in 10,000.

    I'd bet Greg doesn't mention the other issues with a Sub-to, foreclosure, Greg can only foreclose on his interest, that could be paid off, the note to the first seller is pretty worthless, that can end up going to the state in a medical issue, then there are risks of bankruptcy, law suits by other parties, collections and servicing, deed transfers, insurance, liens and the list goes on, which is why you should not do long term subject-to deals.      

    What is Greg's incentive to put this stuff out? If the BS Meter was on, it's not very well calibrated. :)

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  • Alex Franks
    Rock Hill, SC · Member since 2015 · 1k+ posts · 597 votes
    10y
    Originally posted by @Jay Hinrichs:

    @Nicole S.  nothing new your talking about AIDT  that we did in CA in the 70s and 80s..

    My dad had a company called California WRAP  pre internet mind you.

    and yes you can buy a property for X and put a loan on it for Y that is greater than X and the difference is not taxed at that time.. But YOUR BASIS goes up and when you sell you pay tax at that time.

    still a little foggy on exactly what they are preaching..

    Jay when I was just a young lad in this business.  I was buying for 15k fixing for 10k borrowing 35k selling for $39k so taxable gain was small. That was 2004 -6 and I thought I was genius on that. Was happy with my 5 to 10k free and clear on most deals. ( most times my rehab was more then I thought) hence why I said 5 to 10 k

    Alex

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  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    10y

    @Alex Franks  your basis was 25k and you SHOULD have paid tax on the delta between 39k and 25k  if you only reported 4k.. then that is not correct.

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  • Alex Franks
    Rock Hill, SC · Member since 2015 · 1k+ posts · 597 votes
    10y
    Originally posted by @Jay Hinrichs:

    @Alex Franks  your basis was 25k and you SHOULD have paid tax on the delta between 39k and 25k  if you only reported 4k.. then that is not correct.

    @Jay Hinrichs Nope I paid debt on the sale of 39k with borrowed funds of 35k loan pay off

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  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    10y

    my point is if your BASIS is 10k plus 15k  = 25k BASIS for tax purposes..

    regardless if you put a 35k loan on it... if you sold it for 39k minus your closing cost or any other write off your taxable income is the difference between 25k and your net proceeds.

    when you borrow above you basis this is tax deffered IE you don't pay tax on it as its refi proceeds.. ( now some do) but most don't... until you sell the asset.

    I think the point of the post of the OP is that the person giving the talk said that you can shelter or not pay tax on the refi proceeds and that's correct while you own it.. but not correct once you sell you must then pay tax on the True gain  IE basis and sales price as described above.

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  • Nicole S.
    OP
    Investor · Seattle, WA · Member since 2015 · 195 posts · 101 votes
    10y

    @Bill Gulley

    What is Greg's incentive to put this stuff out? If the BS Meter was on, it's not very well calibrated. :)

    You can pay $6,997 to ask him at his "Power Players" seminar in Maui this November. http://www.thecorco.com/products/power-players-whistler-2016

    Both of my friends go to this event every year and swear by it. Both of them are uberly successful in real estate investing. After hearing everyone's comments on this post, I think I need to find two new friends! ;-) 

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  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    10y
    Originally posted by @Nicole S.:

    @Bill Gulley

    What is Greg's incentive to put this stuff out? If the BS Meter was on, it's not very well calibrated. :)

    You can pay $6,997 to ask him at his "Power Players" seminar in Maui this November. http://www.thecorco.com/products/power-players-whistler-2016

    Both of my friends go to this event every year and swear by it. Both of them are uberly successful in real estate investing. After hearing everyone's comments on this post, I think I need to find two new friends! ;-) 

     I don't need to go, LOL, I see his motivation! 7 grand per head!

    A pitch man is going need some really good hype to sell to draw people in, it's most common that these gurus throw out spin on some aspect that is not fully disclosed, like half truths. From that it goes to fantastic and you can get rich following my program. The rest just lie. 

    Well, you can keep your friends, just keep your enemies closer. Your BS Meter should tell you who is who. 

    There are two things that can really mess up your life, taxes and laws, in both areas I really suggest people seek professional advice that pertains to them, not that of what others may think or do. Good luck :)

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