Home equity loans to avoid capital gains upon sale

Tax, SDIRAs & Cost Segregation
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Home equity loans to avoid capital gains upon sale

Ashton Karp
Real Estate Agent · Bonney Lake, WA · Member since 2020 · 40 posts · 27 votes

I am not in a position to act on this question but am genuinely curious about its possibility.

When it comes to capital gains tax, this is paid when selling an asset for a profit after any adjustments that can and are able to be made, but only upon realizing the profits. If I understand, this means that any loans that encumber the asset are deducted from the net profit, therefore lowering the taxable basis.

What limitations are there for encumbering a property that has high equity, prior to a sale, in order to lower the tax basis as much as possible? Are there typically clauses in mortgage liens that would prevent someone from taking a second mortgage and subsequently selling the property?

Excuse me being naive in asking this question.

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Tom DegroodtPro Member
Evans, GA · Member since 2016 · 121 posts · 65 votes
5y

One thing that I think people confuse is if an investor says something like " I bought the house for 100K and it is now worth 200K.  Since I have 100K in equity I think I will refi, rather than pay Capitol Gains tax on it, if I sold it."

What the investor really means is he wants to raise capitol.  To do that he can pull the equity out with a loan, or pull it out selling the property.  If he sells he needs to pay Capitol Gain tax right now.  If he refi's the asset it doesn't change the fact that capitol gains will still be owed - but he is delaying them by keeping the asset.

  1. To further complicate the discussion an investor has at least 3 different ways to not pay capitol gains tax.
  2. 1. Keep the property - Taxes are not due until he sells
  3. 2. Do a 1031 Exchange, thus moving the taxes due as well as the depreciation over to another property.
  4. 3. Die and leave the property to an Heir. 

I believe there are other ways by giving the property away to a non-profit, but I don't know the nuts and bolts for that.

The 2 examples above are simplified obviously.  If he sells he may pay a commission and if he refi's the bank would likely only loan a percentage of the value of the asset,

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  • Christopher Smith
    Investor · brentwood, CA · Member since 2016 · 1k+ posts · 730 votes
    5y

    Encumbering the property changes neither your selling price or tax basis.

    1Reply
  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    5y

    Your loan balance/equity has no bearing on capital gain (profit).  The calculation is the same as if you paid cash....selling price (less actual selling costs) minus purchase price (deducting some initial closing costs and non expenses capital improvements).

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    5y
    Originally posted by @Ashton Karp:

    I am not in a position to act on this question but am genuinely curious about its possibility.

    When it comes to capital gains tax, this is paid when selling an asset for a profit after any adjustments that can and are able to be made, but only upon realizing the profits. If I understand, this means that any loans that encumber the asset are deducted from the net profit, therefore lowering the taxable basis.

    What limitations are there for encumbering a property that has high equity, prior to a sale, in order to lower the tax basis as much as possible? Are there typically clauses in mortgage liens that would prevent someone from taking a second mortgage and subsequently selling the property?

    Excuse me being naive in asking this question.

    Generally, tax basis = purchase price + some closing cost + improvements made - depreciation, if any. 

    Loans are not factored in. 

    Once you make a sale, your loan will be paid off at losing. This is a decrease to your cash proceeds. If your proceeds is not enough to cover your loan at closing, you will have to bring cash on close even when you are selling. 

    You might be paying cash at closing and still pay tax on capital gain. 

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  • Basit SiddiqiBusiness Member
    Accountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
    5y

    Gain = Sales price less adjusted basis less cost to sell
    Adjusted basis = purchase price plus improvements less depreciation taken

    Loan amounts are not factored into the calculation.

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  • Tom DegroodtPro Member
    Evans, GA · Member since 2016 · 121 posts · 65 votes
    5y

    One thing that I think people confuse is if an investor says something like " I bought the house for 100K and it is now worth 200K.  Since I have 100K in equity I think I will refi, rather than pay Capitol Gains tax on it, if I sold it."

    What the investor really means is he wants to raise capitol.  To do that he can pull the equity out with a loan, or pull it out selling the property.  If he sells he needs to pay Capitol Gain tax right now.  If he refi's the asset it doesn't change the fact that capitol gains will still be owed - but he is delaying them by keeping the asset.

    1. To further complicate the discussion an investor has at least 3 different ways to not pay capitol gains tax.
    2. 1. Keep the property - Taxes are not due until he sells
    3. 2. Do a 1031 Exchange, thus moving the taxes due as well as the depreciation over to another property.
    4. 3. Die and leave the property to an Heir. 

    I believe there are other ways by giving the property away to a non-profit, but I don't know the nuts and bolts for that.

    The 2 examples above are simplified obviously.  If he sells he may pay a commission and if he refi's the bank would likely only loan a percentage of the value of the asset,

    2Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    5y

    Thanks @Tom Degroodt.  It is a frequent misconception out there.  And a very sad day when an investor sells a property that is highly leveraged because they think they are escaping capital gains tax.  Only to find that they didn't generate enough cash in the sale to pay the tax!

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