Long Term Capital Gain vs Normal Income Tax

[Daniel Foster]

Below is a question I have asked my accountant, but haven't really been able to get an answer that I can comprehend. Generally I am trying to understand whether it makes sense to capture renovation costs at the sale of a property, to reduce long term capital gains taxes or if it makes sense to allow the expenses to fall to detriment of the bottom line of the profitability of the LLC I hold my properties in. In theory this should reduce my taxable income at my marginal tax rate, which is higher than my capital gains tax rate. Logically reducing my normal income seems to be the obvious choice, but it can't be that simple, can it?

I have some questions on how best to handle our renovation expenses as it relates to selling some houses that we have had in our portfolio for a few years. We have discussed with our 1031 guys and they explained that if we account for all of the renovation expenses for a rental house that we are renovating (specifically as improvements necessary) to sell retail, we can make them part of the 1031 exchange. The expenses would be accounted for at the sale closing. This would allow us to hold back part of the gain to pay off the reno debt and avoid paying Capital Gains Taxes by using the 1031 exchange with the remaining proceeds.

For Example.

Sales Price $200,000

Reno Cost $ 20,000

Cost Basis $100,000

Net Sale $ 80,000

We would then roll the $80,000 into the (1031) purchase of another building and keep the $20,000 to pay back a Line of Credit. This would avoid paying 15% capital gains on $100,000, but still allow us to retain some of the sales to pay off the renovation costs.

Another Example.

Sales Price $200,000

Reno Cost $ 20,000

Cost Basis $100,000

Net Sale $ 80,000

We would then roll the full $100,000 into the 1031 purchase of another building, but would have $20,000 in debt from the renovation. This would avoid paying 15% capital gains on $80,000, but if we then put the $20,000 towards general expense for the property for that year and in theory offsetting our personal income at our marginal tax rate of 30+%

[Michael Plaks]

@Daniel Foster

And your accountant probably has difficulty comprehending your question, so the two of you are even. :)  This is due to you omitting important assumptions and also to partial misunderstanding of the tax rules.

Before you gave your example, your opening question made sense and was actually insightful, thumbs up. But it applied to a very different scenario than what you later presented. Let's say that you poured a $4,000 driveway, which can be immediately deducted thru one of the several tax rules. It can also be set up for 15-yr depreciation. If you take the deduction, it ends up going against your ordinary income. You get tax savings at your tax bracket rate.

If, on the other hand, you set it up for depreciation, there is no instant deduction. Ultimately, it ends up reducing your capital gain at sale. You get tax savings at your capital gain tax rate, which is usually lower. There're some possible complications to this example, which I will not bring up. With taxes, almost everything is case-by-case.

Generally, the deduction scenario wins. And if you're planning a 1031 exchange, it wins even more, because you're deferring capital gain taxes anyway. Again, it's a general rule, with possible exceptions.

What you described as your example is very different, however. First, it's a $20,000 rehab. In most cases, those cannot be immediately deducted, at least not in its entirety, which is a completely different topic, and I will leave it for your accountant to explain. When you do not have an option to deduct it, you have to set it up for depreciation, resulting in increasing your basis and decreasing capital gains deferred via the exchange. If it is done right before selling, it can be treated as costs of selling, with the exact same tax result.

Second, you introduced debt, implying that you will borrow money for this rehab. Debt factors into the 1031 calculations, but not into the tax rates calculations, muddying the waters further. But I will let @Dave Foster shine in his specialty. He will join us shortly, I'm sure.