Is a HELIC considered profit?

Question

CPA’s, accountants, and loan officers please chime in but obviously don’t provide anyone with tax advice, but does my logic make any sense?

I was told once by a lender that debt service is not considered profit.  For example let’s say a real estate investor purchased a home for $100k cash.  Then resonated the home with $50k cash.   Then borrowed 50k in the form of a HELOC and purchased another property.  Then sold the first property for $250k, having invested $150k, then paying off the HELOC of $50k leaving $50k in profit.   Are taxes paid on the $50k in profit as well as the $50k HELOC?

Melody E Bergloff · Answer

@William C.

Let me see if I can restate your question so it is a little easier to follow. Let say you purchased a house for $150K ($100K cash and $50K debt). Your cost basis in the house is $150K. After two years, you decide to sell the property for $250K. You would be taxed on the $100K (Realized gain - basis).

When you borrow money, it does not create a taxable event. In general, you are taxed on only the profit of a sale of a property.

I hope this helps!

Natalie Kolodij · Answer

The actual funds you receive from the HELOC is not a taxable event. Incurring, or paying off debt does not create a taxable event.

Also worth noting in your event- the IRS allows interest tracing. So since that HELOC was used to purchase rental 2. It's essentially treated as a loan against that property since that's where the proceeds went. The interest incurred on the loan is deductible against property 2, not 1. (but that's kind of a side note)

In your Example -

Purchase of $100k, Renovation of $50k = Home basis of $150k

Here is your mixup- a Loan payoff does NOT reduce your taxable gain.

The cash you receive when a house is sold is almost never equal to your gain.

So then you sell your house for $250k

$250k sale price -150k basis = $100k gain - this is what you pay tax on.

Then at closing $50k goes to the lender to payoff that loan

So your taxable gain is $100k, cash in pocket is $50k.

Had you not taken out that HELOC

Your gain would still = $100k

And at closing your cash would also have equaled $100k

You basically took $50k of that early by pulling it out when it was equity, vs. when it sold.

Natalie Kolodij · Answer

Your re-statement changed around what they're saying they'd do.

They are not buying a single  property with both cash and loan.

They're utilizing the BRRRR method- so buying all cash, renovating it, then getting a HELOC against the property.

The proceeds from that HELOC would be used to purchase their next second rental as a cash purchase. Rinse and repeat.

Jay Hinrichs · Answer

what do you mean principle paydown is taxable.

in this scenario as the CpAs have mentioned basis is cash and debt and improvements.. minus sold price = gain.

Wayne Brooks · Answer

@William C. As mentioned,  neither the amount of financing on a property, nor the amount of cash received from a sale, have anything to do with “taxable profit”.  It’s the same whether you pay all cash or borrow 100%...it’s the actual cost basis in the property subtracted from the sales price (less actual selling/closing cost).

Aaron K. · Answer

@Jay Hinrichs I apologize for poor wording my point is only that If you have a mortgage that is $1000 per month and $500 is interest and $500 is principle the interest is tax deductible while the principle paydown is not.  Thus taking on more debt is not a strategy to avoid taxes.

Eamonn McElroy · Answer

@William C.

Debt is a balance sheet movement only.  It never hits the P&L assuming the debt isn't cancelled.  So -- don't even consider it when calculating gain or loss.

Only items of debt that make it to the income statement are interest and loan costs.  The latter of which is amortized over the life of the loan.

William C. · Answer

I appreciate all the responses.   I was afraid that would be the answer.  It’s just a sobering reminder why rentals are so much better than flips.  We just BRRRR’d a house and created $80k in equity that a bank gave us a HELOC on.  Not a taxable event.  But when we sell this flip and create $100k in profit, we’ll be paying Uncle Sam his unfair share.  Might be the last one we do to be honest when rentals create the same amount of cash, with a bonus residual cash flow to boot.

Natalie Kolodij · Answer

It actually is a common strategy. I get what you're saying that having more debt won't reduce tax on a sale, but if you don't sell, there's no tax.

If you need cash to buy more properties. You can sell property A to obtain your $500k in equity within it, use that as down payments on multiple houses. That sale is taxable unless you do a 1031.

OR

You can refinance/ HELOC to pull out the equity without the sale. This allows you to accomplish the same without a taxable event.

Aaron K. · Answer

Yes they are otherwise you would just borrow infinite amounts of money.  Debt service is the interest only, principal paydown is taxable.

Is a HELIC considered profit?

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