BRRRR - Capital Gains on Excess Funds Borrowed Over Basis

[Owen Dashner]

I'd like feedback on a BRRRR scenario from folks who are in the know about taxes related to capital gains. Let's say you buy a property for cash in an LLC, taxed as a partnership (you have a 50/50 partner). It is bought from an extremely motivated seller, so it has a bunch of equity, and is already rented. The purchase price is $85K, the house needs a $10K roof replacement, so your all-in cost basis on the property is $95K. You approach a lender that does an internal valuation (appraisal) on the property, and determines the value to be $140K. This lender will loan up to 85% of the value, so $119K. Assuming the property would still cashflow, if you did the cash out refi and deposited the $119K, you would have $24K of excess cash beyond the basis of the property.

After discussing this scenario with 2 different CPA's, the feedback I have received indicates that if that excess $24K was distributed to the LLC partners for personal use, it would create a taxable capital gain event because it exceeded the amount of basis in the property. But, if the $24K was left in the LLC account and used to pay the operating expenses, it would not necessarily be taxable as a capital gain until you sold the property. Is this correct? Is there a way to capture the equity and be able to use it (other than leaving it in the LLC account)?

Hopefully the above scenario makes sense.  I'd love some feedback from other tax-savvy investors on this.

[Michael Plaks]

@Owen Dashner

As happens 9 out of 10 times, several separate issues are thrown together here, creating confusion in the process.

1. Refinancing and taxes at the time of refinancing. There are none. Capital gains or otherwise - no taxes are due when you do any refinance on an investment property, cash out or not. So your cash-out refi is basically tax-free.

2. Refinancing and taxes at the time of sale. It does kind of catch up with you when you sell the property. Here is how, in a very much simplified example (ignoring depreciation, closing and holding costs and tons of other factors). If shortly after this refi, you sell the property for $140k (which you said was its value) and pay off your $119k loan, you walk away with $21k "profit" (remember, we ignore all closing costs for simplicity.) Most new investors expect to be taxed on $21k. 

However, they are actually taxed on $140k - $95k = $45k  (again, ignoring depreciation and depreciation recapture.) In essence, while you were NOT taxed on $24k cash pulled out at the time of refi, you end up taxed on this cash when you eventually sell. The technical explanation, for those who care, is that debt does not affect tax basis for gain/loss purposes.

3. Deductibility of interest on the refi loan. This issue, mentioned by @Steven Hamilton II, has nothing to do with any other issue in this thread. it's on its own. Most investors assume that when they get a loan secured by an investment property, the interest is automatically deductible. Wrong. The interest may be fully deductible, may be partially deductible, and may not be deductible at all. It depends on how the proceeds of the loan are used, on the timing of the loan and on the funding history of the property. It has been often discussed on this forum if you care to search.

4. Taxation of gains in pass-through entities. If a partnership makes any gains - capital, ordinary, whatever - they will end up taxable to the partners at the end of the year. For example, if a property is sold. It makes absolutely no difference whether the proceeds are kept in the company's bank account, reinvested into another property, spent on getting quality tax advice (the best use of the money, in my opinion) or distributed to partners to be blown in Vegas (the second best use).

5. Taxation of partnership distributions. This issue is completely different from the one above. When the company makes money, it creates a taxable event for the partners, as explained in #4. When some or all of that money is pulled out of the company and distributed to partners, it has already been taxed, so it is usually tax-free. 

However, an additional issue might arise, to which your two CPAs alluded: sometimes, the distributions might exceed the partners' basis in the partnership - which is completely different from the partnership's basis in a property. It's a complicated issue, but it's highly unlikely to be your problem, as Steven already said, because partners' basis in the partnership is increased by debt assumed by the partnership (unlike what happens in S-corporations.) 

Bottom line: you can refi, distribute the money to yourselves and spend it. No taxes now. You might regret it when you sell the property, as it will become taxable then. Or you might regret it sooner when you realize that the money could have been spent on acquiring more properties.