Capital Gains and Equity Put In

[Jason L.]

This question has puzzled me for some time; oddly, I cannot find an answer. 

Hypothetical Scenario: I'm a newb in real estate and I purchase a property for $100,000. Over two years, I've put $20,000 in equity into the house via paying down the principal (no improvements). After these two years, I decide to sell the house. I will sell the house for $100,000 (same as what I bought for). When this transaction is done, I will be receiving $20,000 profit thereabouts (not considering closing costs, agent costs, etc).

So here is the question: Would I have to pay capital gains on this money I receive since it technically isn't "profit"; it was money I SPENT and am merely just getting back. How do I prove this to the IRS or would the IRS even know of this transaction?

How DOES the IRS know when you made money from the sale of a house?

[Jon Holdman]

I'm going to back you up for a minute.  When you buy a house with a mortgage and make your payments, there are two parts to those payments (assuming this is a amortizing loan and not an interest only loan.)  Part of the payment is principal and part is interest.  The interest is truly an expense.  That's the cost you're paying for all that money you borrowed.  The principal, however, is not an expense.   Its a transfer.  Its exactly the same as if your paycheck gets deposited into your checking account and then you transfer some money to a savings account.  The equity in the property is YOURS.  The principal payment may feel like an expense.  But its really simply a transfer from your bank account to your property equity account.   Its your money before and after the transfer.

A credit card is the same.  In a monthly budget you should never have a line item for "credit card payment".   That "payment" is just a transfer from one account to another, not an expense.  The money you spend on the credit card is an expense.  And the interest you pay on that card is an expense.  But the transfer from your bank account to the credit card account is not.

So, when you sell a house at the closing, all that money that's in the equity of that property comes back to you as a check from the title company.  Its not profit.  Its your money, before and after the sale.

The profit on a sale is the selling price, less selling costs less your basis.  Your basis, in this example, is your purchase price plus purchase costs.  So the reality is if you buy a property for $100K and sell it for $100K a few years later you will have a loss on the order of $10K because of the purchase and selling costs.