How are elements of BRR taxed?

Question

Let's say my wife an I are general managers of an LLC who buys a single family home.  The contract price is 100,000.  We put 20,000$ of materials and labor into it.  We then rent it out for 12 months and cash flow 10,000.  We then sell it for 150,000.

Do we pay 15% tax rate on the 10,000 cash flow?

Do we pay long term capital gains on 50,000?

Do we have to pay a property manager for the cash flow to be considered passive income?

How does claiming depreciation affect capital gains?

Thanks everyone in advance!

Micah Epps · Answer

Thanks, Dave and Paul.

Paul Allen · Answer

Welcome to BP @Micah Epps !!!

Assuming cash flow = rental income, then you pay normal income tax rates on it.

Yes, in your scenario you would pay long term capital gains rates on the capital gains.

Rents are passive income with or without a property manager.

Depreciation expense claimed will be repaid when the property is sold. The tax rate on these (inelegantly named) unrecaptured section 1250 gains is typically 25%. You wrote 'claiming depreciation' as if it was optional. It isn't. There's a really long explanation why, but the short version is "you have to claim the depreciation expense".

Best of Luck with Your Real Estate Investing!

Dave Toelkes · Answer

@Micah Epps

i am assuming that your original intent for this acquisit9ion was to hold this property for the production of income.  To simplify my answer, I am also going to assume that you paid cash for your $100K purchase and also paid cash for the cost of materials and supplies used for the rehab.

You said that your cost of materials and labor for the rehab was $20K.  If you did all the work yourself, you can not charge for your own labor; you can only add the cost of materials and supplies to your rehab costs.  For purposes of this discussion, let's say that all the rehab work was done by contractors who billed you for the cost of materials and for their labor.  Now you can include the labor cost in your total project cost.

Let's also assume that your county tax assessor has determined that 20% of your property's value is attributed to the land, and 80% to the dwelling structure (called improvements).   This means that your tax basis in this property is $120K ($100K purchase + $20K rehab), of which, $100K ($80K dwelling structure + $20K rehab) is your depreciation basis.  You cannot depreciate the $20K land value.

Once the rehab was completed, you put the property into service as a rental.  After one full year and a day of rental use, you decide to sell to your tenant who offered to pay you $150K.  During the year of rental use, your net operating income was $10K which will be taxed as ordinary income at your marginal tax bracket rate.  You had $30K in long term capital gain due to appreciation ($150K sale proceeds less $120K cost basis) which will be taxed at the long term capital gains tax rate applicable to your marginal tax bracket rate.  During your year of rental use, you also had $3636 in capital gain due to unrecaptured deprecation.  This unrecaptured depreciation will also be taxed at your marginal tax bracket rate, but no higher than 25%.

You do not need to use a professional property manager for your rental income to be passive.  Your residential rental activity is still a passive income activity even if you manage the rental yourself.

This simple answer is meant to give you an appreciation for some of the tax impacts you will face.  My response would have been much more detailed and complicated if I had assumed you used financing for your acquisition, and/or you had a net tax loss in spite of a positive cash flow.   You don't give us enough information to determine your capital gains or ordinary income tax rates, so I can't give you a specific answer to your question about your capital gains tax rate.