i was speaking with a builder last night about real estate and taxes. he mentioned that he gets taxed 15% because it’s not ordinary income. I was trying to get clarification but i guess a few brewski’s hindered him from being clearer
was he bs’ing or am i missing something here. how is this guy only getting taxed 15% and not hit with capital gains?
You pay EITHER captial gains rate or ordinary income. This is sometimes referred to as long term versus short term capital gains but for the lay person, it’s confusing to say it that way.
So just look at it like this, either it’s ordinary income (taxed accordingly) OR capital gains taxed at 15%. The capital gains rate is for an asset owned for 12+ months. Shorter durations are taxed at your ordinary rate.
for a builder it should be ordinary income taxed at his marginal rate. his marginal rate “could” be 15%.
if he’s a sole proprietor, partnership or LLC being taxed as one, he would also pay self employment taxes on top of this. a C-corp or LLC being taxed as one would avoid the self employment taxes. An S-corp might.
Your tax rate depends upon your use of the property. If the property is investment use, then your holding period determines your capital gains tax rate. If the property is dealer realty, then the tax rate is your ordinary income tax rate or your corporate tax rate.
What did you tell the tax advisor about your investment strategy that prompted the 30% response? What is your marginal tax bracket?
BTW, if the builder is operating from a C-corp, then the tax rate on his first $50K of net taxable income is 15%. Maybe the builder did not tell you the whole story. I wouldn’t be surprised if the builder was blowing smoke, because builder’s I know don’t really want to reveal their profits and are somewhat tight lipped about their income.
I spoke with my tax advisor many months back. I recall him asking me about my current salary tax bracket. Then saying if I sold my home within the two years the total tax i would be hit with would be around 27% give or take. I wish I had more details, but I cannot recall at the moment.
This property was for investment use (to fix and sell), but with the large tax (and some other factors) I’m going to live in it for the 2 years.
You mention a differnece between dealer realty and investment use…it seems dealer realty would allow for a larger profit, however i’m not sure what the differnce is.
The more info I get from variouis sources on taxes the more confused i get … I plan doing more deals in the near future, however i’m still uncertain as to how i can limit the taxes that i’ll be hit with.
By definition a sub2 seller (the distressed current owner) can’t make a profit off the sale, the lender doesn’t allow it. So they certainly don’t pay taxes. The LLC will eventually sell the property and at that time they will pay taxes based on the net income from the sale of the property and its ‘on-the-books’ value (assuming it’s been depreciated).
Let’s see if we can’t clear up the definition confusion, with respect to the IRS.
If you are living in the property as your primary residence or second home, the IRS says you have a personal use property. When personal use property is sold, the capital gains tax rate appropriate for the holding period applies. When your holding period is at least two years and you have been using the property for your primary residence for at least two years of the five years prior to the sale as your primary residence, the IRS will allow each taxpayer to exclude up to $250K in profits from long term capital gains taxes.
If you are holding the property for the production of income, or holding for future long term appreciation, then you have an investment use property. When investment use property is sold, the capital gains tax rate approptiate for the holding period applies. Depreciation taken during the holding period (or depreciation that should have been taken) will also be recaptured at 25%.
If you are holding the property primarily for resale to customers (such as flip property, and most builder inventory), then you have dealer realty and the sale of dealer realty is called a dealer disposition. All of the profit (both realized and unrealized) on a dealer disposition is taxed as ordinary income and payroll taxes may apply as well. Dealer realty can not participate in a 1031 exchange, can not use installment sale tax treatment, and can not be depreciated.
Note that the IRS definitions are very specific and narrowly defined. While you may consider any property you purchase and may later sell for profit an investment, the IRS will tax the profits from the sale of the property according to your use.
Dave T, thanks so much for the info. This is something that really confused me as I was looking to get into new construction partnering with a builder. I was assuming that I would have to pay capital gains PLUS ordinary income tax rates. With new construction I see how a person could easily be in the 30% plus tax bracket with the profits that are obtainable.
One question to add though…
If I have an LLC taxed as an S-Corp (3 partners) and all are employed and paid a salary and after all expenses we make a profit of $300K (building and selling homes) that is distributed equally at $100K each. Will we just pay 15% tax of the distributed money and regular taxes on our payroll?
S-corp distributions (or LLC taxed as S) are tax free.
The tax is paid when the income is passed through from the S to your personal returns. It is taxed whether you make a distribution (write a check to yourselves) or not.
having said that, S-corp (or LLC taxed as S) income typically is taxed at your personal rates PLUS self employment taxes. However, if the three of you are employed BY THE LLC, then the LLC income passed through to you can avoid self employment taxes as long as the salaries are reasonable and other criteria are met.
If you’re not an employee OF THE LLC, you should be.
No, S-corp income flows through to your personal tax return and is taxed according to the nature of the income. In your case, I believe, the distribution in excess of salary is a non-qualified dividend distribution and ordinary income tax rates apply on your personal income tax return.
$300k in dividend income should put you at or very near the top income tax bracket.