Buy & rehab last year, sell this year, what to do for taxes?

Question

Simple answer might be: consult CPA / get one. I'm trying to see if there's a rule of thumb of sorts.

I recently rehabbed a home late last year, and spent a lot of money doing it (it exceeds my income from my normal job). We are selling the home now.

So my question is how do I put this on my taxes? Do I take a loss (it is my only property last year) on last year's taxes equal to the cost (purchase + rehab) of the home, and then when I sell this year, that would be income? Or is there another method?

Issues are: if I put the loss this year, i'd be in the negative (normal job income minus rehab) and wouldn't fully benefit from the deduction. Come next year, I would have the sale plus income, which will probably put me in a different bracket thus doesn't seem good. This is especially concerning since the investment is so large in this home but we don't anticipate making much of a profit on it (due to various issues). Thoughts?

Bill Exeter · Answer

Hi Bruce,

I completely understand your points.  I think the real issue is not that the 1031 Exchange is bad but that many investors that do 1031 Exchanges end up buying replacement property that they should not have purchased.

I think the right approach is to structure a 1031 Exchange if you are going to reinvest and then let it fail on purpose if you can not find anything that makes sense.  It just requires discipline to know when to walk away and not buying something just for the sake of the 1031 Exchange.  The 1031 Exchange should always put you in a better position, and if it doesn't, then you should not proceed.  Sometimes it is just better to walk away and pay the taxes, but it does not hurt to try.

Steven Hamilton II · Answer

Be careful not to do that too often or it CAN be re-characterized as a trade or business.

Steven Hamilton II · Answer

Rami,

Everything you invested into the property is considered inventory. This means you will not deduct those costs until you sell the property.

Dave Foster · Answer

@Bruce Runn, Understand the identification pressure.  What most people don't realize is that you're not locked in to max value at all.  As a matter of fact one of the strongest aspects of the 1031 is that you can sell highly appreciated (maxed out value) real estate and purchase multiple cheaper value add properties.  And by deferring the tax through 1031 you also get use of the unpaid tax to ratchet up your purchases even more. This is commonly referred to as a diversification exchange.

Example - You bought a duplex for 100K and now after holding it long enough to get cap gains treatment you're ready to sell for 200K.  Your options are:

1. Sell and pay the long term federal cap gain (18.8% best case).  Pay State cap gains (7.85%) and recapture a year at least of depreciation (maybe another 740).  Total tax you pay would be around $27,000.

2. Sell and do a 1031 exchange and buy a 200K property - this is your max value situation.  You save 27K in taxes but give yourself the upside on one larger property.

Or you could....

3. Sell and do a 1031 exchange purchasing two 100K duplexes.  You saved 27K in taxes and now you have the potential to replicate what you did the first time - turn each of those into 200K duplexes maxed out on value.  The ability to diversify into greater numbers or more advantageous geographical locations and then consolidate as your investing cycle matures into larger less hands on projects is a key component to using 1031s successfully

Absolutely as said above the 1031 has to leave you in a better position.  But there are ways to do that without stroking that big tax heck

Bruce Runn · Answer

I am not an advocate of 1031's as it tends to force you into buying situations that are not ideal in order to move out/sell a position in another.    It's better for me to pay the long term capital gains and reinvest at a much lower price point.   My goal is to buy less expensive duplexes that have a lot of upside and fix them up for cash flow/maximize profits.  In 80-90% of the cases, I keep and hold long term.   If/when I sell one of mine, I'll gotten all the upside potential out and could only end up with another finished/renovated product as I've added a lot of value to what I owned and have to buy another property in the same price range.  Since I'd be selling one of my properties at the high end of the market, I don't want to buy another at the high end.  I don't like the perpetual maxed out value.

Dave Foster · Answer

@Bruce Runn,   "No mans person property or liberty are safe as long as the Legislature is in session" (or there is an IRS field office open).

But what you describe sounds like an investor rather than a dealer in real estate.  Demonstrable intent is the key.  Hold and document these kinds of conversations with your cpa/attorney/real estate agent/business or property manager

That being said there are some things that make that intent more demonstrable.  the fact that you are holding at least a year would have pushed those properties into capital gain category in the past.  In the case of a 1031 exchange it also separates the initial purchase and subsequent sale on to two separate tax returns so in a one return audit it would raise less questions.

@Steven Hamilton II does make an excellent point.  If you're going to that length to secure capital gain treatment it's not a far leap to completely defer (eliminate) that tax using 1031s.

Never do the wrong thing just because you can get away with it.  But likewise, never not do the right thing just because it might be questioned.

Dave Foster · Answer

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Steven Hamilton II · Answer

My advice would be to start doing 1031 exchanges in those cases. Otherwise @Linda Weygant pretty well summed it up.It is all facts and circumstances.  The more sales the more it looks like a business.

Bruce Runn · Answer

@linda

@Linda Weygant

The answer is always of course my "100% intention" is to hold onto every property/manage them/rent as I do.  I don't and never would have a realtor license where that would be my a primary role in my business.  Every year I look at how my business and properties are doing so sometimes, I change my mind as my circumstances/available money changes and sell one of my places and in all those instances, it comes after 1 year.  That should qualify (99% of the time as I understand anything can be challenged) as a long term capital gain-right?

Linda Weygant · Answer

@Bruce Runn - As with most tax questions, the answer is, "It Depends".

If these are properties that you rehabbed and rented out, with the intention of renting them out all along, then the sale almost always qualifies as a capital gain.

If these are properties that you rehabbed, held and sold, with the intention all along of selling them right away and you were waiting out a long term holding period, then the sale almost always qualifies as business income (subject to SE tax, etc).

@Brandon Hall wrote a great article about this.  The IRS generally looks at intent as well as actual facts and circumstances of each transaction.

TL;dr - holding something for a year and a day will not necessarily make it capital gains.

Buy & rehab last year, sell this year, what to do for taxes?

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