Another capital gains question

Ok, I have heard conflicting things about this so I am going to put it out there for everyone.

I am starting rehab on a house and we plan to have the rehab done in about three weeks. I know I will be paying short term capital gains but I don’t know where to figure them from so here is my question:
Do I figure the total tax by taking
(Cost Sold - Cost Purchased) x 25% = Total Tax
(Cost Sold - (Cost Purchased + Expenses)) x 25% = Total Tax

(Federal income tax bracket - 25%)

Thanks for your replies

Since you are working a rehab flip, the tax picture is a little more complicated than just ordinary income taxes (capital gains does not apply). First some formulas.
Cost of Goods Sold = Purchase Price + Acquisition Cost + Rehab Cost + Holding Costs

Net Sale Price = Contract Sale Price - Selling Costs - Seller Concessions

Flip Profit = Net Sale Price - Cost of Goods Sold

Net Self Employment Income = Flip Profit - Business Operating Expenses

Remember that property flipping is a business. In the absence of a formal business entity, you are a sole proprietor and your income is self-employment income. Your business likely has operating expenses, too, that you don’t want to overlook such as office supplies, business cards, magnetic signs, yard signs, dedicated telephone and fax lines, utilities, office rental, web-site development and maintenance costs, etc. These operating expenses are your costs of being in business but not attributable to a specific property – in other words, your overhead costs. Costs that are attributable to a specific property are included in the “Cost Of Goods Sold”.

Determining the federal income tax on your net self employment income requires two calculations – one for ordinary income tax and the other for the payroll taxes on your self-employment income. Your federal income taxes will be computed on Schedule C and Schedule SE.

The ordinary income tax calculation is easy enough to estimate. Just use the tax tables and look up the ordinary income tax due for your filing status. If you are married filing a joint return with net flip profits equal to $100K, then the ordinary income tax on your flip profit will be $18,330 (from the 2005 tax tables). Perhaps even lower because I disregarded the standard deduction and personal exemptions that lower your taxable income. On the other hand, your taxes could be higher if you have other taxable income.

Let’s also assume the same $100K net self-employment income for your payroll tax computation. First let’s calculate your Adjusted Net Income From Self Employment. Do this by reducing your Net Self Employment Income by 7.65%, or by $7650. This gives us an Adjusted Net Income From Self Employment of $92350. You take this reduction because one half of the 15.3% payroll tax is a deductible expense to your business.

Social Security Taxes only apply to the first $90K of income (from all sources) in 2005. So, even though you have more than $90K in adjusted net self employment income, only the first $90K is subject to social security taxes. If you have earned income from other sources, such as your day job, then that income also counts toward your $90K social security income cap. For this example, let’s say that you are flipping property full time, and this flip income is your only income during the year. Under these circumstances, the first $90K of your flip income multiplied by the social security tax rate of 12.4% gives you the amount of your self-employment income taxes allocated to social security, or $11,160 in this example.

The second piece of the payroll taxes is for Medicare Insurance. The Medicare tax is 2.9% with no maximum base. Thus all of your Adjusted Net Income From Self Employment is subject to the Medicare tax. In our example $92,350 x 2.9% = $2678.15

Your total self employment income tax will be $13,838.15 in this example ($11,160 + $2678.15) Adding the payroll tax and the ordinary income tax components together, you determine that your maximum tax liability is $32,168.15

As I said earlier, your actual tax bill will be even lower if you have other earned income. For example, let’s say you have a day job that pays you a $90K salary. Now, since you already have $90K in social security income from your day job, you have NO social security tax on your self employment income because only the first $90K in earned income from ALL sources is subject to the social security payroll tax. Note, also that I used the social security income cap for 2005 in my example. I don’t know what the income cap is for 2006, but if inflation adjusted for 2006, the cap will be higher than $90K.

Great explanation, Dave. Welcome back.

Just to clarify the “capital gains does not apply” statement for bobc. Capital gains is for “investment” property defined as buying to hold for appreciation. A rental would apply here, also.

Buying to fix up and sell is NOT a capital transaction. It’s just like buying buggy whips to re-sell. You’re selling an inventory item; it’s just that your inventory happens to be one house.

“Adding the payroll tax and ordinary income tax components together…”

Can you show me how you did that for this example?

$18,330 + $13,838.15 = $32,168.15

I tend to use the terms “payroll tax” and “self-employment income tax” interchangeably