Tax question: capital gains

I’m new to real estate investing. I bought my first rehab in April 2011 with cash borrowed from a private lender. I am taking the homestead exemption and have been living in the house while I’m rehabbing it. I plan on closing in February and stand to profit around 50 thousand dollars. My question is will all the income be taxed for 2012 since I am receiving the cash in 2012? Since I made all the improvements in 2011 is there a way I can have my income taxed for 2011? Otherwise I will have very little income showing for 2011 and a lot for 2012. I think this is called the accrual method. I’m aware how it works for rental properties but I’m not sure how it applies to a rehab. Thank you for your help.

Rehabs are not capital gain. They are ordinary income on your 1040 Sch C.

You are taking a homestead exemption and living there. That makes this a residence, not a rehab. Residence gain is capital gain, which would be to your advantage, since capital gain rates are lower and you don’t pay self employment tax (FICA/Medi) on the income as well. (The total tax bite on rehabs is ~ 45%). You still get to claim the improvements as an increases to basis (cost) but you would not get to claim some of the other expenses related to the rehab. I’m guessing that unless the other expenses are enormous, you’d be better off with the much lower capital gain rates on slightly higher overall income.

I would recommend that you take the residence route and just do the capital gain for lower taxes.

Plus, if you live there for a full 24 months, you would be able to exclude 100% of the gain from your income. This will be determined by the date you actually sell the property, so you don’t have to make any decision until the property sells. If you live there less than 24 months, I’d take a look at the safe harbors for a reduced exclusion, which may still eliminate most or all of the gain from your income.

HOWEVER, if you really want to treat it as a rehab, then the cost of the house and all improvements are treated as inventory/cost of goods sold on the Sch C in the year sold.

Other expenses not incorporated as part of the rehab (tools, etc) are expensed in the year purchased, again on Sch C.

Some expenses, such as utilities & insurance are now in a gray area, because you used the property as your residence during the rehab period, and personal expenses are not deductible. I would have to ponder how to split the “rehab utilities” from “residence utilities.” It may not be enough to bother with either way. This would apply to the mortgage interest as well, but at least here the personal portion would still be deductible on Sch A.

You are not an accrual basis taxpayer.

Good luck.

Just to add to Mark’s comments.

You bought the property in April 2011 and will be selling in Feb 2012. Since your holding period is one year or less, your capital gains tax rate will be the same as your ordinary income tax rate. Even though the tax rate will not be the lower preferred rate that applies to a long term holding, you do avoid the payroll taxes on your sale profit if the house is sold as a primary residence rather than as a flip.