Advice on Capital Gains Tax

15 Replies

Hi everyone,

I am very new to real estate, in fact, I haven't even begun yet. I have been a BiggerPockets fan for years! I listen to the podcast and attend the weekly webinars in order to learn as much as possible.

SO! I potentially am going to have my first deal lined up, it is a condo that is ironically next door to my parents. 

I am an Assistant Superintendent for a fairly large General Contractor in the Boston area as my day job and am graduating with my Bachelors in Project Management. The project management portion of this potential deal I am very confident that I have that under control. 

My biggest concern is my lack of expertise in the real estate transaction itself and also more importantly Capital Gains tax if I were to flip it. I would like to get some input on any suggestions on how to avoid or minimize this tax. I get the general concept, I just would want to know if it would affect me.

The purchasing price of the condo is $90,000....Rehab is estimated for $20k-$25K and the ARV should be around $155K-$175K. I would plan on rehabbing it and selling it within a year. What are the implications I would run into with the capital gains tax and I guess my biggest question is "What am I missing".

Am I over-analyzing capital gains??


I look forward to hearing from all of you!

Thanks,

DJ

AM NOT A CPA OR TAX PROFESSIONAL.

My main thing would be to get with a CPA and make sure you structure this right.  If you are just doing all this to flip it, it may be treated as "inventory" which gets you worse tax treatment (like as ordinary income vs. CapGains.)

If it is CapGains (NOT ordinary income), you'll need an accounting anyways.  You need to figure the basis + cost to buy + Capital Improvements (things you do that are depreciated instead of expensed).  

If you DON'T take depreciation, then when you sell and get an adjusted sales price you need to take out your adjusted cost basis (without depreciation) to get appreciated CapGain.

If it's CapGains, then you need to look at what bracket you're in to figure your rate which could be up to 20%.  Then you add in about 4% for MediCare tax and if your state (like OR) has income tax, they get a slice.

TLDR - GO TALK TO A CPA/TAX PROFESSIONAL BEFORE YOU DO ANYTHING.

Originally posted by @Steve Morris :

AM NOT A CPA OR TAX PROFESSIONAL.

My main thing would be to get with a CPA and make sure you structure this right.  If you are just doing all this to flip it, it may be treated as "inventory" which gets you worse tax treatment (like as ordinary income vs. CapGains.)

If it is CapGains (NOT ordinary income), you'll need an accounting anyways.  You need to figure the basis + cost to buy + Capital Improvements (things you do that are depreciated instead of expensed).  

If you DON'T take depreciation, then when you sell and get an adjusted sales price you need to take out your adjusted cost basis (without depreciation) to get appreciated CapGain.

If it's CapGains, then you need to look at what bracket you're in to figure your rate which could be up to 20%.  Then you add in about 4% for MediCare tax and if your state (like OR) has income tax, they get a slice.

TLDR - GO TALK TO A CPA/TAX PROFESSIONAL BEFORE YOU DO ANYTHING.

 You don't get to take depreciation on inventory/ flips

Generally flipping is Ordinary income

This means it is taxed at your regular rate and subject to 15.3% self employment tax.

@Daniel Black Congrats! I love hearing about people making the first step into REI! and the short answer to your question in my opinion is no you can't over analyze anything! Short term capitol gains can absolutely kill you from a profit standpoint. So I think it's important to decide what is your main goal or agenda out of this deal? Do you want to try and make the most money? Do you just want to do it for the experience so even a break even would be a win? just things to ask yourself. I am not a tax professional but to my understanding (and this could be totally wrong so please fact check me) the short term cap gains tax is considered an "active" income, if you make the investment profit inside of 12months. So then you are subject not only to the larger cap gains rate but also FICA taxes like unemployment and social security, thats why when your all said and done the tax rate can effectively be upwards of 50-60% on flips.

The easiest way, again as I understand it, is to hold the property for more than a year, even if its 12months and 1day, you then are only paying the long term cap gains rate.  I'm not sure how you are financing this but the lowest tax rate you could get on this would be to actually live in the property as your primary residence for at least 2 years, and then you get up to 250K in profit tax free.  That specific IRS rule is: you need to live there "2 of the last 5 years" prior to selling it, and they don't need to be consecutive years.

Long of the short of it is that the cap gains is taken on the profits of the deal, and if you can wait till after 12 months, either keeping it as a rental, or having it as a residence, or even a short term rental, you drop your tax rate from upwards of 60% to potentially as low as 15% depending on what your normal tax bracket is.  The IRS has some pretty simple cap gains rate charts you can google that will tell you right where you sit.

Anyway, hope I didn't muddy that too much for you, and good luck!  keep us updated on the deal!   

Thank you for everyone’s reply! My next question would be is the capital gains on just the profit from the flip? Or will I get taxed on my total income including my regular salary? 

Michael to answer your question, I am trying to learn as much as possible, if I make money it’s a bonus. I obviously would love to make money but that’s not the ONLY factor. 

@Michael K Gallagher @Natalie Kolodij @Steve Morris

@Daniel Black your normal W2 job will continue to get taxed as normal, and then your additional income form the flip will be taxed as the short term cap gains (only on profit from flip). However, unless you shelter that income in an LLC or something similar you are technically taxed on the total income (W2 plus profit from flip). So if the additional income pushes you into the next tax bracket then you could end up with a higher than normal tax liability because your overall earnings pushed you into the next income bracket.

Even if you do perform the flip inside of a LLC you could still end up with the same above issue if your LLC is structured as an S-corp or other pass through entities. So doing the flip in an LLC really ends up opening up a whole other can of worms! not that it can't be done, just more to consider.

Can everyone please stop telling OP that his income will be capital gains. 


A flip is only capital gains if it wasn't intended to be a flip. Kind of a one off. 

If you buy a flip with the intent of reselling for profit that's a business to the IRS. That will be ordinary business income subject to 15% Self employment tax on top. 

Your w2 income will be taxed at ordinary income tax rates as normal- as will your flip income. 

Your % that your ordinary income is taxed at will be based on your overall income for the year- check out the 2020 IRS income tax brackets. 

Then the flip income on top will also include self employment tax.

@Natalie Kolodij , please clarify the ways that a flip can be long term capital gains. It's my understanding that there is not an active business if the intent is to rent out the property . The mere act of remodeling a property does not mean you have to pay FICA taxes as if running a business. The capital gain is short or long depending on holding period. Investors should contact a knowledgeable CPA or tax atty. that has helped others navigate generating capital gains rather than business income.

Originally posted by @Todd Goedeke :

@Natalie Kolodij , please clarify the ways that a flip can be long term capital gains. It's my understanding that there is not an active business if the intent is to rent out the property . The mere act of remodeling a property does not mean you have to pay FICA taxes as if running a business. The capital gain is short or long depending on holding period. Investors should contact a knowledgeable CPA or tax atty. that has helped others navigate generating capital gains rather than business income.

 Whether something is ordinary income or capital gain is based almost completely on INTENT.

If you buy a property and you say to yourself, I'm going to improve it and resell it as quickly as possible - that's a flip.  And it's Ordinary Income.  The IRS does not care if you buy a house, improve it and sell it or buy computer components and assemble them into a PC.  It's the exact same business model.  It's employment and it's taxed as ordinary income at the regular tax brackets and subject to Self Employment taxes.

If you buy a property and say to yourself, I'm going to rent that out to tenants, but first I need to improve it to get top rent.  And then, at any point along the way, you end up selling it - that's capital gains.  Long term vs short term depends on holding it under or over a year.

Here's the difference...

A rental is like buying stock.  It's the asset itself that produces income.  A rental property produces rental income and a stock produces dividends (whether the stock actually pays dividends is immaterial).  So when you sell an asset that generates its own income, it's a capital transaction when you sell it.

A business is when you buy and sell a product.  That can be any widget or resource on the planet, or it can be real estate.  When the item IS the product, and the only way to produce income is to sell the product - that is a business.

Make sense?

Originally posted by @Todd Goedeke :

@Natalie Kolodij, please clarify the ways that a flip can be long term capital gains. It's my understanding that there is not an active business if the intent is to rent out the property . The mere act of remodeling a property does not mean you have to pay FICA taxes as if running a business. The capital gain is short or long depending on holding period. Investors should contact a knowledgeable CPA or tax atty. that has helped others navigate generating capital gains rather than business income.

 If you say: I'm buying a product to alter and re-sell for profit. That's a flip. 

That's a business to the IRS. 

It's not that he remodeled a property- it's that he specifically did it with the plan to re-sell for profit. It has nothing to do with holding period. 


If he remodeled it and then rented it for a while (most say at least a year) then there can be an argument to it being capital gains since it was an investment property not inventory. 

My self and other tax pros on BP have commented to this effect over and over again.