Tax Implications for BRRRR?

23 Replies

I'm curious what the differences are for tax implications for a straight flip vs. a BRRRR? My understanding is that any profits from a flip will be taxed at my personal current tax rate as income. However, if I'm refinancing and getting an 80% LTV loan, any "profits" after the cash out on the refi would be debt on the 80% LTV loan. Would there be any self income that I need to report to the IRS if the extra money is debt?

For example on a flip: $60k all-in on purchase, rehab, and financing w/ ARV of $140k, the profits would be $80k but would be taxed at my personal income level

On a BRRRR: $60k all in w/ ARV of $140k and 80% LTV loan on the refi, the cash out would be $112k and profits would be $52k. Would this $52k be tax free since it is part of the refi debt?

Thanks!

@Hunter Preston ,

I'm not a tax professional, but in my experience you only pay capital gains when you SELL the property. You will claim that income in the future when you sell the building, because you bought the building for <$60k.

When you flip real estate you realize income on the sale of the property, and that gets taxed at ordinary income tax rates. Income from flipping is also subject to self-employment taxes.

When you BRRRR you do not sell the property, you rent it. If you have rental income (after expenses) your rental income is also taxed at ordinary income tax rates, but it is not subject to self-employment taxes.

Money the bank loans you on a refi is borrowed money. Borrowed money is not taxable as income. 

Best of Luck on your Real Estate Investing!

@Paul Allen  

Do you need to own the rental home for a certain period of time before you sell it in order to not pay self-employment tax?

Be careful on the flips. Yes, if you were to do just 1 flip a year, your profits would likely be taxed at personal income rate. But if you were to do 2 or 3 or more a year, you would be considered a dealer. And, as a dealer, you would likely be stuck paying self employment taxes on those profits too.

Now you're looking at 33 to 37% or something like that? I'm not sure as I only do buy and hold. But something to keep in mind.

In terms of the tax implications of the BRRR strategy. When you do the refi, it doesn't matter how much money you take out or gain on the refi. Its all tax free to you.

It won't change your tax basis though so if you buy it for 90k and put 10k into rehab, your tax basis will be 100k. So even if you refi'd at 120k, your tax basis still remains 100k. 

If you turned around and sold it for 120k the next day, you would pay off the loan of 120k and end up being taxes as a profit of 20k (120k sales price minus 100k tax basis).

Still buy and hold is far better for taxes than flipping.

Last I checked the IRS has no hard and fast rules on whether you are classified as an investor (buy & hold) or a dealer (flipper).  The courts have come up with a 15-point checklist to determine your 'intent'. (The courts settle the disputes that arise when the IRS classifies someone as a dealer and they want to be an investor.)

  • Taxpayer's purpose for acquiring, holding and selling the property
  • Number, frequency and continuity of sales
  • Duration of ownership
  • Time and effort expended by the taxpayer in promoting sales
  • Taxpayer's use of brokers
  • Extent of improvements and subdivision made to facilitate sales
  • Ordinary business of the taxpayer
  • Extent and value of the taxpayer's real estate holdings
  • Extent and nature of the transactions involved
  • Amount of income from sales as compared with the taxpayer's other sources of income
  • Taxpayer's desire to liquidate landholdings unexpectedly obtained
  • Taxpayer's overall reluctance to sell the property
  • Amount of advertising
  • Use of a business office for sales
  • Taxpayer's control over any sales representatives

A flip is taxed at ordinary income rates and it is generally subject to self-employment taxes.  There are ways to limit self-employment taxes by using an S-Corporation but there are additional costs to consider.  There is no difference for anyone who does 1 flip vs someone who completes 5 in a year.

Generally, a cash out refi is not a taxable event, this is not the case of a property owned in a corporation.  Assuming you are transacting business in your personal name it will not be an issue.

If you are renting the property and own it for over a year and sell it - the gain will be subject to capital gains tax rates (typically lower than ordinary) and you won't have to pay self-employment taxes.

@John Woodrich Does that included LLC's? If I buy a foreclosure in an LLC, rehab, rent it out, and then refi then I could be taxed on the cash out?

If the property is owned in an LLC a cash out refi is generally not a taxable event.

This is the reason why flipping just doesn't make a lot of sense to me. In your scenario, they'd be taxed on the $80k profit, which would kill the profits. Realistically you wouldn't get $140k when you sold it anyway. You'd get $140k - 5% commissions, - $2-3k closing costs - misc fees. Maybe you'd walk away with $130k. You could refi for $112k, so realistically you're only leaving $18k of the profits in the deal and that $18k is what you'd get stuck paying in taxes on the $70k-$80k anyway, so really, you're not leaving a penny in the deal.

By simply holding the property a year or two, selling it and 1031 exchanging it into the next property, and doing this indefinitely through their life, they would never pay taxes on that $80k and continue to make income off it. 

Find a good CPA that works with investors AND has investment properties ask them about tax rates and a business model that works for you. They may be able to save you $$$ on taxes.

@Chase Gochnauer I have clients who have sold flip properties and paid tax to lock in a higher sales price.  Their plans were to purchase another property however it made no sense to purchase a bad deal to avoid taxes.  At the same time they didn't want the hassles and risks of making it a rental.  Good deals can take some time to find and when one comes up they want cash to make it happen.  Sure you could get cash with a refi however you would be paying interest every month for cash sitting in your bank account.

I hear about a lot of people who will rent a property for a period of time to convert their flip income to capital gains.  If you can avoid paying ordinary income taxes that is good but for most people the difference is only 10%.  10% can be lost in wear and tear in one year or easily lost if the market starts to decline.  In the example above, if his gain is $80,000, the additional tax would only be $8,000.  If the market declines 6% he would lose more than $8,000....  One bad tenant could easily cause $8,000 of damage to cabinets, floors, etc...

These reasons alone are why flipping makes sense for people.  Sure you have a little more money to invest if you don't have to pay the tax but at some point you will have to pay the tax anyhow.  

It is good to structure transactions with tax consequences in mind however I wouldn't structure a transaction solely because of taxes.

@John Woodrich

@Chase Gochnauer I have clients who have sold flip properties and paid tax to lock in a higher sales price.  Their plans were to purchase another property however it made no sense to purchase a bad deal to avoid taxes.  At the same time they didn't want the hassles and risks of making it a rental.  Good deals can take some time to find and when one comes up they want cash to make it happen.  Sure you could get cash with a refi however you would be paying interest every month for cash sitting in your bank account.

I hear about a lot of people who will rent a property for a period of time to convert their flip income to capital gains.  If you can avoid paying ordinary income taxes that is good but for most people the difference is only 10%.  10% can be lost in wear and tear in one year or easily lost if the market starts to decline.  In the example above, if his gain is $80,000, the additional tax would only be $8,000.  If the market declines 6% he would lose more than $8,000....  One bad tenant could easily cause $8,000 of damage to cabinets, floors, etc...

These reasons alone are why flipping makes sense for people.  Sure you have a little more money to invest if you don't have to pay the tax but at some point you will have to pay the tax anyhow. 

 Hey John. You mention purchasing a bad deal to avoid taxes. I don't necessarily agree with this. You essentially have 75 days from the day you receive an offer on your property, to identify another property for 1031 purposes(30 days closing period plus 45 days from closing). I think 2.5 months is ample time to find a reasonable deal.

I do agree that if someone absolutely does not want a rental, then it would not work. I would argue though that refinancing would give you just as much cash as you would receive if you flipped it. You would be paying interest, but I'm getting 4.5-4.75% rate now, after tax deductibility it's in the 3's. So I'm paying 3.X% to have the money sit in my account, and avoiding 20-39% ordinary income taxes on my gains in the process.

The difference in my mind is much more than 10%. It's 25-39% depending on your bracket if you are 1031 exchanging. If you profit $100k that year on your flips, we're talking 10s of thousand of dollars in saved taxes. 

Your estate does need to pay the taxes one day, but if a person is 30 now, it may be 50 years before the estate has to pay the taxes, no difference than the tax benefits of investing in a 401k. As long as a life insurance is in place equal to the taxes a person would pay on the gains, then it's a wash. This is the only reason a whole life plan made sense to me.

Here's the way I think of it -

Scenario 1:

Purchase for $50k + Rehab for $20k = Total invested $70k

Sell for $100k - $5k misc fees = $95k net - $70k invested = $25k profit

$25k profit - 25% ordinary income taxes = $18,750 spendable money

Scenario 2:

Purchase for $50k + Rehab for $20k = Total invested $70k

Refinance for $100k @ 80% LTV with $1k in misc fees = $79k cash out - $70k invested = $9k cash now

Hold for 24 months:
- $100/mo cash flow = $2400
- Depreciate $5,400 = $1363 in tax savings
- Profit from holding = $3763

Invest the entire $3763 in repairs on the property to get it back to $100k sellable condition

Net $95k - $77,500 mortgage payoff = $17,500 profit which is rolled into the next property via 1031 exchange(more complicated with basis I know) to do the same thing over, or hold for a longer period of time

Total profit = $26,500 tax free

By holding 24 months you've gained approximately $8,000. Of course it's dependent on your tax bracket. It may not seem significant on a single property but if you are doing 6 a year this would be $48,000/yr in savings/gain.

Happy to have anyone punch holes in the philosophy. I agree there's risk of market crashing and tenant destroying, but as long as you're doing a reasonable volume of these I think the numbers would average out to the above. As far as the market goes, this would just change the philosophy into a hold pattern until the market recovered. I think also this model would have you adjust how you handle the initial rehab in which you do the basics up front and do the balance of the cosmetic repairs at the end of the 24 months.

@Hunter Preston ,  There is no profit or taxable gain recognized without a sale.  A refi of any kind is placing debt on equity.  You get the cash but it's not taxable.

But that sort of proves the point everyone is making.  Flipping involves purchasing with the primary intent of reselling as quickly as possible to access cash.  Accessing profit through a sale of a flip lands you in a world of tax hurt.

BRRR involves purchasing with the intent to hold. Accessing cash by a refi of a brrr does not create a taxable event.

Flipping is more work  Flipping is higher risk.  Flipping is lower return per investment.  Flipping is higher tax.  Flipping is also way more fun and a good source of your daily adrenaline fix. And done in a high enough volume or with just the right property it can be very profitable.

I'm lazy, I don't like risk.  I like my money to work for me not me working for my money. I can skydive or ski Mary Jane if I want adrenaline.  That's why I like buy and hold (most times).

I understand the tax side of it - my only point is that treatment shouldn't be the only decision driver. 

My comment on the 10% tax rate differential was geared toward the difference in paying ordinary and capital gains rates.

I disagree with you about the ample time to find a reasonable investment.  I don't invest to try and hit singles, I am trying to hit home runs.  I am actually closing on a flip I am selling this afternoon.  I already have a contract on a separate unlisted 4 plex.  Had I been able to setup a 1031 (can't on a flip) I would not have wanted to invest all of my proceeds anyhow and would still be stuck paying tax...   Sure I could have tried to complete a refi to pull out cash for the 4 plex purchase but it makes sense to lock in the gain now instead of take on market risk and risk of damage on a house that needs no work.  At the same time, the debt of the refi and the new debt of the 4 plex will be a big hit to my debt-to-income ratio - it may ruin my ability to use conventional financing.

Outside of the property I have in contract there is not another property I would like to purchase right now.  I am going to work on the next renovation on a property we already own and continue to look for a deal.  Forcing myself to buy a reasonable investment to meet the 1031 requirements could be a big loser if we have another market correction.  

Sure, taxes are a bit part of it but structuring a plan solely for tax purposes is not a good idea.  That is all I am saying.  If you can defer the tax you are generally better off but you are not better off if tax strategy forces you to complete a bad purchase to avoid tax or if your tax strategy limits your future growth.

@John Woodrich , Wondering where self employment tax starts to rear its ugly head for the avg flipper?

@Dave Foster that would depend on where their other income was at, if they have a big W-2 or another business the SE tax may be minimal :)

Taxes are important but they are not everything.  They can help make decisions but they should not be the only driver in making a decision.

Also consider if you have SE income you may be able to push alot of it into a solo 401k.

I didn't read everything in all the replies, but it basically boils down to the time holding it.  When you flip, it's assumed you aren't holding it for more than 12 months.  In that case, it's taxable just like W-2 income.  It's "active" income and is just added onto your tax liability for that year.  Consult a CPA as to whether self-employment taxes or anything else come into play.  If you do hold for more than 12 months, it's capital gains.

When you refi, you aren't selling.  Any income from the refi is "tax-free".  Tax-free is in quotes there because nothing is ever tax-free, what you are doing is just delaying taxes until you sell.  Depreciation recapture and the profit you make when selling is what is used to determine taxes, but refi doesn't trigger a taxable event at that time even if you get cash back.

Accounting is another matter. Flipping and BRRRR have different ways of handling the accounting as with BRRRR, there is a point where things start becoming expenses as opposed to something you roll into your depreciation. typically with flips, it's all the same thing.

And of course there may be things at play that cause what I said to be different, but I'm trying to keep it general for the purpose of your question.

Originally posted by @John Woodrich :

I understand the tax side of it - my only point is that treatment shouldn't be the only decision driver. 

My comment on the 10% tax rate differential was geared toward the difference in paying ordinary and capital gains rates.

I disagree with you about the ample time to find a reasonable investment.  I don't invest to try and hit singles, I am trying to hit home runs.  I am actually closing on a flip I am selling this afternoon.  I already have a contract on a separate unlisted 4 plex.  Had I been able to setup a 1031 (can't on a flip) I would not have wanted to invest all of my proceeds anyhow and would still be stuck paying tax...   Sure I could have tried to complete a refi to pull out cash for the 4 plex purchase but it makes sense to lock in the gain now instead of take on market risk and risk of damage on a house that needs no work.  At the same time, the debt of the refi and the new debt of the 4 plex will be a big hit to my debt-to-income ratio - it may ruin my ability to use conventional financing.

Outside of the property I have in contract there is not another property I would like to purchase right now.  I am going to work on the next renovation on a property we already own and continue to look for a deal.  Forcing myself to buy a reasonable investment to meet the 1031 requirements could be a big loser if we have another market correction.  

Sure, taxes are a bit part of it but structuring a plan solely for tax purposes is not a good idea.  That is all I am saying.  If you can defer the tax you are generally better off but you are not better off if tax strategy forces you to complete a bad purchase to avoid tax or if your tax strategy limits your future growth.

 I guess it depends again on your model. If I could only find 1 house every 75 days that hit my goals then I wouldn't be able to grow at the pace I wanted. I've averaged probably 2 a month for the last 2-3 years. They're not all home runs but they're solid doubles. I tried to build a business model around rehabbing/renting property, rather than one here and one there. I don't know that it'd be possible to do that if I focused only on home runs. 

I don't really think about a market correction since I'm strictly a buy and hold person. Had I bought a ton of properties in 2005/2006 right before the crash, I'd still be up in value and rents today versus '05/'06. I only would have had a problem had I wanted to exit the properties in 2007-2013.

@Chase Gochnauer unfortunately I don't have the ability to purchase 2 properties a month yet but I am not levered up at all. Without getting commercial financing I know it would be hard to make the DTI requirements if I tried to lever up on everything so my goal has been to capitalize on some flips to build even more buying power before taking on debt. Right now I am sticking to areas I am familiar with and in my location there are many people willing and able to buy so having a means to purchase is essential.

Originally posted by @John Woodrich :

@Chase Gochnauer unfortunately I don't have the ability to purchase 2 properties a month yet but I am not levered up at all. Without getting commercial financing I know it would be hard to make the DTI requirements if I tried to lever up on everything so my goal has been to capitalize on some flips to build even more buying power before taking on debt. Right now I am sticking to areas I am familiar with and in my location there are many people willing and able to buy so having a means to purchase is essential.

 I'm in a bit of a different position as I have an entirely separate business that does pretty well, but working with a lender to do a conventional loan that will be resold on the secondary market is a major headache compared to a local bank that has a local board approving the loans. If you can find a good local bank to work with, it's much easier to grow. Amortizations are shorter, 20-25 years, but rates are comparable and closing is much simpler.

@John Woodrich

Hi John,

I didn't see it mentioned yet, but there is another tax advantage not discussed.

If you did the BRRR, because you are planning on living in the property, you can stay for two years and own for 5 years, while renting it out for 3 years, qualifying you for a $250k Capital Gains Exclusion per person or $500k Cap Gains Exclusion for a married couple. Of course this would only be on the portion that is your Primary Resident and not the rental part, but then you can 1031 Exchange the rental part as well.

The Tax laws, to me, in my humble opinion, is really skewed towards the BRRR Investor.

I agree that the tax laws favor the BRRR strategy but if someone is only chasing tax strategy they may get limited pretty quickly. I have worked some newer investors who were all excited to grow with the BRRR strategy and their plan was foiled because they ran out of income in the DTI calc.... It is a good strategy for beginners although it is not very scalable.

You are correct on the gain exclusion, that is actually what I am doing now.  Renovating my next house (a prior rental with a low cost basis) and I plan to rent my current house for a couple years before selling.  I think this is the last time it will work though, my wife has been itching to upscale a bit so we can pursue taking foster children.

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