Avoiding capital gains....

[John Pelaez]

I recently bought a duplex and am going to rehab one of the units. It should cost me around 5-8k to do so. In the mean time I sold a property and profited about 38k. I know i will have to pay taxes on the 38k. My question is if i use at least 7600 (20% of 38k)on the rehab of the duplex unit, would that negate my capital gains tax obligation?

[Natalie Kolodij]

Unfortunately this was setup kind of backwards- a 1031 exchange would have been possible to defer any capital gains tax, however it would have needed to be setup before purchasing the new duplex. 

At this point, there will be capital gains on that property sold. How are you calculating the $38k? 

Capital gain will be calculated as: 

(Sale price - Selling costs) - (Purchase price - depreciation + improvements + purchase costs)

Additionally, the portion of the gain that is related to the amount of depreciation that was taken on the property will be taxed at your ordinary tax rate, up to 25%. 

There are a few items that will come into play. 

The first being your tax bracket- If you're in the 22% bracket tax will be roughly $8,000ish. 

If you're then spending $8,000 in improvements on the new rental there will be 2 items to look at:

1. If the improvements are over $2,500 they will likely need to be capitalized and depreciated, so you won't get to take the full $8,000 in this year. 

2. If the improvements are lots of smaller stuff, no major repairs, all under $2,500...you would get to take the $8,000 this year. 

However- $8k in expense will not wipe out $8k in tax. 

It will reduce your taxable income by $8k - which will result in $1,7000 ish in tax savings. ($8,000 x 22% tax bracket)

If you have other expenses, depreciaton, ect- your rental may generate a potential tax savings greater than that $1,700. 

Also keep in mind, rental income/losses are passive and can only offset other passive income unless you're a small taxpayer or RE pro. 

If your Modified adjusted gross income is $150k (if married) or lower then you can utilize any rental losses taken (that $1,700 will overall reduce your tax liability) However if your MAGI is over that, the loss will carry forward to next year.