Expenses turned Income at Settlement

[Jeff R.]

Rookie mistake. So I just closed on a sale and received the settlement check and was more than expected. I soon realized that the check had over budget expenses that I paid out of pocket included. So my renovation was estimated at $35,000 (hard money) and I came out of pocket to cover the over budget of $12,000, $47,000 repair when done. It was a small flip that got pricey, nevertheless, the house is sold. But now I am holding a check that has $12,000 of personally invested funds that will now be taxed as income for 2018. Any recommendations?

[Michael Plaks]

@Jeff R.

There's no rookie mistake as far as getting the money. It's perfectly normal. There's, however, a rookie confusion about how taxes work on flips. :)

Checks from closing do not matter for tax calculations - not at all. Sounds strange, I know. Bear with me.

For the calculation, imagine the whole deal was done in cash. 

1. You take the sale price from the second closing. This is what you would have received in cash if financing was not involved (minus closing costs).

2. From this number, subtract everything you put into this property:

• initial full purchase price (as if you paid it all in cash)
• closing costs at purchase
• closing costs at sale
• full rehab cost, whether paid from escrowed money or from your cash (because ultimately all of it was paid out of your pocket)
• holding costs like insurance and taxes

This represents your profit, without financing considered.

3. And now subtract the cost of borrowing money: interest and fees. Just make sure to not double-count the fees if you already included them with the closing costs at purchase.

And now you have your true "gross profit."

4. Not done yet. You get to subtract all expenses of running the business: driving, marketing, education and whatnot.

Whatever is left after all your expenses is what you will be taxed on, known as "net profit."

The check you received at sale reflects some pieces of this calculation, but the number on the check is nowhere to be seen in the tax calculation.

You're good. Keep at it. Just may need some tax help.