Will I pay ordinary income or long term capital gains?

Question

We are selling a property we have purchased in Nov. 2018, and are scheduled to close on May 8th.

We did a rehab on it, used the brrrr strategy and rented it out from June to January to a short term insurance deal that paid great money.

Things have come up in our household and we decided to sell this property to pay for some other stuff.

My question is, wouldn’t I pay long term capital gains on this gain because we have owned it this long? We’re about 131k into it and selling for 189k. My accountant told me I’d probably be paying between 15-20k in taxes on it. Sound right? To me that would be the number if it was added to my ordinary income, but if it was a lower rate(long term) then I should be more like 8-10k from what I’m reading.

Thanks for any input.

Lance Lvovsky · Answer

Based on the facts you presented, I would take the position it is a long-term capital gain. Ask your accountant how he (she) supports their position for this to be ordinary income. Maybe there are other facts he(she) knows about your deal, but it sounds like capital gain to me.

Whitney Hutten · Answer

@Brett Loetz Glad to see @Dave Foster chimed in. There is a breakeven point on a 1031 where it makes sense to do one. I think you have to find that point. To level set this. You could explore the 1031, then if you can't find a deal, you are out the exchange fee (just don't buy a deal because you HAVE to). If you are OK with that and what it could save you, that could be huge! I think deals will be coming online in the next month... Some investors are going to be done and not want to fix things up prior to sale.

Glenna Wood · Answer

As an investor who has done several 1031 exchanges, there are a couple of key things I think through to decide if I'm going to 1031 or simply pay taxes on my gains: 1) Do I have enough $$ after the exchange to buy a suitable replacement property? If it will be down payment $$ instead of full purchase, do I have a suitable loan lined up? If I take on debt, is the return in the new property worth it? 2) Have I researched and found suitable replacement properties that I'm 99% sure will close to meet the 1031 windows? 3) Does exchanging into other RE at this time make sense for my overall plans? Can I better use my profit on something else right now? I would try to avoid paying capital gains now and then buy more RE in a few years as the taxes paid would have been a good chunk toward another property.

One thing FOR SURE I would barely consider is the cost of doing a 1031 exchange. That "cost alot" advice sounds pretty odd to me. I think I paid $650 to my QI in my last exchange (a simple sell this buy that with all my prep work done). I've never had a QI charge me based on the amount of the exchange. It's a "do I want to pay taxes now or later" decision.

Congrats on having a profit! Paying taxes on it bites but nothing wrong with hitting the cash register if that looks best.

One thing FOR SURE I would barely consider is the cost of doing a 1031 exchange. That "cost alot" advice sounds pretty odd to me. I think I paid $650 to my QI in my last exchange (a simple sell this buy that with all my prep work done). I've never had a QI charge me based on the amount of the exchange. It's a "do I want to pay taxes now or later" decision.

Congrats on having a profit! Paying taxes on it bites but nothing wrong with hitting the cash register if that looks best.

Alex Olson · Answer

@Brett Loetz 1031 should be less than $1000 depending on purchase price. We can chat further if you like!

Andrew Syrios · Answer

If you've owned it for more than a year, it should be long term capital gains. But this is a question you should clarify with your accountant.

Jacob Sampson · Answer

I would think it would be long term capital gain but keep in mind you pay on the difference between what you sell and your basis. If you have been taking depreciation, as you should, then your basis is lowered by that amount. For example if you have taken 10k in depreciation then it is capital gains on 189 - 121. Not 131. Of course you will subtract out transaction costs as well.

Just some thoughts.

Eamonn McElroy · Answer

@Brett Loetz

Probably best to go back to your accountant, as it seems you're not exactly sure what he/she is doing, and we can't help with that.

Agree with Lance, probably a 1231 or 1221 gain. I don't see property held for sale here but I haven't had the deep convo.

Brett Loetz · Answer

@Glenna Wood

Thanks for all the great advice from everyone!

I now definitely know a 1031 isn’t “too expensive” and it would be great to not pay these taxes now but with the challenges my family is currently facing i think it’s best for me to hit this cash register once.

On the other “bright” side, I should be finished with the rehab on my second brrrr within two weeks so I’ll still have 2 single family rentals after selling off what was my first brrrr. 👍🏼

Dave Foster · Answer

@Brett Loetz, Dude you have my admiration! I looked at your profile to see what state you were from to maybe shed some light on that abnormally high tax potential and see you're a high voltage electrician - Wowsers!!

@Lance Lvovsky and @Eamonn McElroy have been there and done it. I too would think it would be a LT capital gain with a very little bit of depreciation recapture. Unless you're a high earner thats 15% fed. Getting to 15K in taxes seems high but we don't know the whole story.

But... a 1031 exchange isn't that expensive. https://www.biggerpockets.com/blog/how-much-does-a-1031-exchange-cost. $750 to save $15k - $20K kind of seems like good path if you're planning on reinvesting anyway. Your accountant is out of touch with that issue. I'd double check their interpretation of your gain as well.

Brett Loetz · Answer

@Whitney Hutten

He claims he deals with real estate, but depending how this years taxes go. I might look around for another one.

We thought about the 1031 exchange actually. Problem is finding a deal good enough I would be able to refi out of in just a few months in our market right now.

Also my accountant told me doing a 1031 on this property with this equity probably didn’t make much sense since the 1031 exchange itself can cost a lot. Does that sound right?

He said you mostly want to do them on properties where your looking at a bigger profit or where you have been claiming depreciation for 8-10 or more years and you could be paying a lot in “recapture” fees. This was one of the eye opening times I thought maybe he’s not the best accountant for me because what I’ve read online would make me think differently about the 1031.

Will I pay ordinary income or long term capital gains?

Will I pay ordinary income or long term capital gains?

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