Capital gains taxes

[Patricia Lashley]

Well, gentle people, I find myself up a creek without the proverbial paddle.

And PLEASE FORGIVE my apparent ignorance about such a basic topic as my questions below.

For reasons, which I won't go into here, I found myself 10 months ago, having to rehab 2 houses instead of one, and both turned up with issues not previously known or planned for. In fact, lots of stuff happened, which I can use to justify what may have been bad judgment on my part or just a series of unfortunate circumstances.

In the long run, matters not how I got here, but how I get out of HERE. Right? :)

The short version of this post is: If I sell a property and do not reinvest in another, am I paying taxes on ONLY previous purchase price minus sales price, on the profit, after taking into account money I may have put into it for improvements, or on the entire sales price?

If I have to reinvest, am I having to reinvest all of the sales price, to avoid taxes, or only the difference between what I owe on the mortgage and the sales price, or what I paid for it and the sales price?

Long version:  I am now out of cash. Have used practically every last dime, and am 99% done on one house - just have to find cash for locks, a plumbing fix for something that happened yesterday, a sudden electrical problem (no juice in any outlets in the kitchen), a general clean up, and I will be ready to rent and have money coming in, after paying the mortgage, on time, for more than a year.

On the other house, I need 2 new AC units, for which I do not have the money, new carpets in 6 bedrooms, which I can swing, fixtures, ceiling fans, shower doors. And I am done. The contractor for everything except the AC units, has been paid, with only $1k owing so I really need to just find the money for the AC units, and I have none. :)

One of the properties we own, is a STR in the Disney area. It is not bringing in consistent money. Lately, it is not bringing in any money at all and while I have bookings late this year, and a scattering next year, there is no guarantee that I can turn this around. Conventions in the Orlando area are canceling left, right and center, because of the immigration laws just passed, because of the tension of the whole LGBTQ thing and whether you are a supporter of the present Governor or not, is really irrelevant to this, my problem, because this is what is happening in this area.

In 6 years of owning this house, I have never NOT HAD the house booked for July 4th weekend, labor day weekend, Halloween weekend. Yet this is it this year. And I just got a 3 night booking for Thanksgiving weekend at a rate so low, I shudder to think about it. :) This is the one house that is not easily converted into a LTR as it is 8 bedrooms, SF, with a private pool, in a gated STR community, with an HOA, and limits on how many long term rentals there can be. And I do not foresee being able to rent it long term ever.

If we sell, we can walk away with approx. $300k, which would allow me to finish that one other house, give me a cushion, just as my husband thinks about retirement. Plus free me of $3000 in obligations every single month, with no money coming in.

I tried to get a second mortgage. Was not successful and a refi would put us further in the red every month, if the rental trend continues.

Between the properties we own, we have over 1.3M in equity, conservatively, but that does not really do me any good because refi-ing is out of the question.

Anyway - thanks for reading all of this - it did me well to vent, even if only by typing up this stuff and I really want to know about the taxes so I can consider my options.

God bless.

[Scott Trench]

I'm sorry you are finding yourself in a tough position! I look forward to hearing from one of the tax pros or CPAs on the site in response to this question, and you should definitely go talk to one of the folks who reply here, or by looking for "tax professionals" (under "build your team" in the navigation bar). 

I think that a good amount of this will have to do with how long you've owned the properties. If you've owned these properties for a long time period, then a capitalized "improvement" like a roof, will add to the basis of the property. If you own them for less than a year, they are flip, and improvements will be expensed along with any "repairs". 

An example: 

Case 1: You have a $275,000 house. Your "flip" consists of repairing a broken front door for $100 and replacing the roof and the wraparound deck for $27,500. You sell the property for $350,000 less than a year later. 

Your profit is $350K less $27,600 in expenses, less $275,000 in purchase price. You pay ordinary income taxes at your marginal tax bracket on $47,400 in profit. 

Case 2: You have a $275,000 house. Your "hold" consists of repairing the broken door for $100 and replacing the roof and wraparound deck for $27,500. You sell the property for $350,000 three years later. 

Aside from the cash flow you hopefully have generated, you have a capital gain. This is more complicated than the flip example. 

First, you need to depreciate the property. Land does not depreciate, the structure or "improvements" depreciate. In this case, let's pretend the land was valued at $0, and the structure is worth the entire $275,000. We depreciate this every year for three years over 27.5 years. That's $30,000 in depreciation. The basis in the property declines from $275,000 to $245,000. 

Second, you need to capitalize and depreciate the improvements. The improvements are a roof and a deck. The useful life for a roof and deck are each 27.5 years, per the IRS (you can look this up with a simple google search. We paid $27,500 for these improvements and did them immediately after purchase. The improvements get added to the basis, which increases from $245,000 to $272,500. 

But wait, we also have to depreciate these improvements. They depreciate by $1,000 per year over three years. 

Our basis, after all this confusing work, is now $269,500. 

We expense the $100 door agains the income of the property. This is a "repair" and similar nominal items like lawncare, unclogging the toilet, patching drywall, etc. would be in this category. 

When we sell this property, our taxable capital gain is the sale price of $350,000 less the basis of $269,500. Or, $80,500. This will be taxed at a long term capital gains tax rate of 0%, 15%, or 20%, depending on your taxable income at the federal level. 

Whew. How crazy is the US tax code? 

Of course, please check all of that with a tax pro, and see if one of them tells me how wrong I am about this. And, probably hire them to help you with this and get everything right to manage taxes at the time of sale. 

Now, let's zoom out to the strategy piece: 

The tax tail should not wag the business dog. You have an asset that is burning a hole in your pocket, and likely close to $250K (after capital gains taxes are paid) or more to redeploy into something that is much more likely to appreciate in the near term, and that can produce a lot more cash flow. 

I find it hard to believe that the right approach for you in this situation is anything other than paying Uncle Sam his slice of your capital gains pie, and redeploying this equity elsewhere. Again, check with a tax pro, but I'm inclined to think it's time to exit this property based on what I am reading here. 

You are also out of cash. A sale of a property with $300K in equity that is negatively cash flowing solves that problem in a very major way.