Balance was 56.4K. Refied at 85%ltv which put me at 83.3K. Pulled out the cash difference (around 22K-23K)…do I pay taxes on borrowed money? What happens this year when my tenant/buyer decided to buy it from me? Then do I pay gains? I’ve owned the property for 6 months now. Any help is appreciated,
Nate-WI
Refis have no tax implications because the money out is borrowed…
Sales have a tax consequence…capital gains can be either short- or long-term gains.
Keith
I understand I will be paying gains…however what do I pay on? Do I pay on the 83.3K versus what its bought for from my T/B or do I pay on the 56.4K versus what my T/B buys it for?
Nate-WI
You pay taxes on the “gain” (the difference between your purchase price and your selling price minus any improvements/allowable expenses)…if you bought it for $60K and sold it for $85K, the gain is $25K less any capital improvement/allowable expenses…the loan balances have nothing to do with the gain…with what you’ve posted, there is no real way to determine your taxable gain.
Keith
Can you give some examples of allowable expenses that would be considered part of the sale? (advertising/marketing costs/fees, agent/broker fees, taxes (sales? other?), any other kinds of fees (escrow?, insurance?)… ???)
Does the gain for a non-owner occupied rental get taxed at the regular income rate or I thought I read something about a special gains rate of 25%?
How does the annual depreciation factor in? Is the initial purchase price depreciated for this calculation?
Thanks for your help.
anything that cost you money is deductible somewhere, either as a selling expense or added to your basis reducing gain. There’s an IRS publication on this – 551 maybe? I can’t remember off the top of my head and I’m too lazy today to go look. Dave may argue with me, but I just take prorated taxes and insurance to expense and book the rest to basis. Any difference is immaterial.
Rental property held more than a year is a capital transaction and any gain is a capital gain. (as opposed to flips which are ALWAYS ordinary income, but I digress) taxed at 15% this year.
depreciation reduces your basis (increases the gain) but the gain from depreciation recapture is taxed a little differently. Pub 544 for more on this.
I am not going to argue with Mark’s answer as it relates to expensing/capitalizing expenses on the HUD-1. I would also expense interim mortgage interest and any “points” paid to secure financing.
From your question, however, it appears that you may be acting as a dealer to real estate for this property. You bought it six months ago and “sold” it on a lease option. If this is the case, then all your costs are adjustments to your basis – the “cost of goods sold” on Schedule C. You don’t recover any direct expenses for the property until the option is exercised.
hmmmm… I know a contract for deed is considered a “sale” for taxes, but does a lease option give the tenant an equitable interest that would also be considered a sale?
I don’t know the answer to that. Dave?
Not to barge in on your question for Dave but -
Mark, you were right about IRS pub 551 about info on determining basis. Thanks. From pub 544: Is a typical long term hold rental property considered a section 1231 property and if so, is the depreciation recapture typically taxed at the ordinary income rate? So there could be good years and bad years to sell depending on my regular income?
Mark,
Gordo acquired the property six months ago and put a lease option tenant in right away. I can imagine that the IRS will interpret his activity has always having the intent to sell. I can hear the IRS auditor’s argument now.
“Mr Gordo, you purchased the property and immediately sold an option to purchase your property at a mutually agreed price. The length of time that your buyer takes to exercise his option does not change the fact that the property is simply being held for sale to your buyer, until your buyer decides to exercise his option. Your activity suggests that you never had any intent to hold for the production of income as would be demonstrated for investment property. We have determined that your intent was to always sell the property, the lease option is simply a technique to facilitate a delayed sale. Therefore, we deem that your primary purpose for the acquisition was to hold the property for sale to your customers and the sale is a dealer disposition.”
“Mr. Gordo, depreciation expense taken during your holding period is disallowed, the long term capital gains tax treatment you took on the sale is disallowed. Your sale profit is taxable as ordinary income and self-employment income taxes apply”.
Mark, I would tell Gordo to report all his “rental income” as ordinary income on Schedule C. I would tell Gordo to report the acquisition and sale of the property for the tax year when the option is exercised. Until then, all costs directly related to the property, to include mortgage interest, are accrued and included in the cost of goods sold on Schedule C.
Just how I see it.
D Kame,
An investment rental property is a section 1250 property. When you sell, unrecaptured depreciation is taxed at 25% regardless of your ordinary income tax bracket at the time
I see your point, Dave. Well put and well received.
Thanks for all you do.
I agree that the IRS might challenge your intent to hold the property long term if you immediately put it under a lease option rental agreement. However, I think you have just as strong an argument that you have every intent to hold the property long term. The lease option is just that an option with an expiration date. So long as the option fee received up front is insufficient to classify the transaction as a sale (accountants help me out here) then it is a lease transaction. The option could even be argued to be a tool to facilitate the rental of the property in a competitive marketplace. As an alternative you could write your lease option such that it cannot be exercised for a period of say six-twelve months, just enough to get you to the twelve month long term holding period.
71tr,
I see holes in your arguments.
If you want to argue that you have every intent to hold the property long term, then why did you sell an option that obligates you to transfer title to your buyer whenever the buyer decides to exercise his option, even if he exercises the very next day? Selling the option demonstrates your intent to sell the property, rather than holding for long term rental use.
If you have received option consideration, then you have sold an option to purchase the property. The amount of the option consideration is irrelevant in determining whether a sale has occurred – it has, you sold the option.
If the option agreement is a separate agreement from the lease agreement, then there is no way anyone should confuse the option agreement with a lease transaction. If you combine the lease option and rental agreement into one document, then the buyer could argue equitable interest and if the court agrees, you have entered into a sale agreement.
Arguing that the lease option simply facilitates the rental of the property is weak. How does marketing to potential buyers and agreeing now to a delayed sale demonstrate your intent to hold (perhaps indefinitely) for investment rental use. If you wanted to hold the property for long term investment use, a reasonable investor would not use a lease option to facilitate rent. A reasonable investor would only use the lease option to facilite a potential sale.
Placing a restriction on when the tenant buyer can exercise the option gets you nowhere. Dealer realty is dealer realty no matter how long you have held the property. I read a story about a taxpayer who bought land at a depressed price then put it on the market for sale. Since it took ten years to sell the property, the taxpayer claimed that the sale was the sale of investment property eligible for capital gains tax treatment. The IRS argued that because the property was always for sale during the ten year period, the taxpayers primary intent was always to hold the property for sale to customers. The court agreed and ruled that the sale was a dealer disposition.