I sold a house. What do I owe the IRS?

This call comes almost weekly:
Michael, I just sold this house for $110,000 and my mortgage was only $100,000, but I did not actually make $10,000 – they gave me a check for only $4,000 after all these stupid fees. Do I really have to pay taxes on the entire $10,000 or just on the $4,000 I received?

Answer: Neither. Your mortgage has nothing to do with taxable profit.

Another perennial question:
Michael, I’m thinking about selling this property. It is appraised at $120,000. So, if I sell it now for, say, $125,000 – will my capital gain be $5,000?

Answer: Nope. Appraisals and market values have nothing to do with capital gains.

And, finally, my favorite:
Michael, I bought this flip almost 2 years ago. You know, in this awful market it is so hard to sell! I finally closed last month. Hopefully, since it was more than one year, I will only have to pay 15% “long-term” capital gain, right?

Answer: Wrong. This is not capital gain at all. You may owe as much as 40%!

If you already knew that all three questions were off the mark, you may not need to read the rest of this article. But if at least one of my answers was news to you, please join the club (and I do not mean the RICH club here) and keep reading.

1. So, what is taxable profit?

This concept is easy and – believe it or not – even logical. You pay taxes on the money that you made from each property. “Made” means exactly what it means: how much more money you have after the deal, compared to what you had before the deal.

We’re talking real money and real profit, as in “cash.” This is why appraisals and comps mean nothing for taxes: it is not about how much you could’ve sold it for – it is how much you really did sell it for. More exactly, it is how much you have left in your pocket after you sold it.

Let’s take an example. You go to a Tuesday auction and buy a piece of work for $25,000 cash. It then takes another $35,000 to equip this so-called investment with important but missing items, such as the back wall and roof. Maybe even doors, windows, and AC – if you have money left in the budget. By now, you are $60,000 out of pocket. So far, pretty simple, right?

Now, you manage to sell this freshly painted and finally habitable house for $90,000. This should put $30,000 in your pocket – if not for commissions, seller incentive and various closing costs. After all these extras, you may have only $22,000 of profit left. Now, if you also subtract advertising, insurance, utilities, property taxes and all those other bills that eat into your profit – you’re left with $20,000 “real” profit. What is your taxable profit for the IRS? Amazingly, it is $20,000.

Even a hardcore IRS hater (and you know who you are) should agree that this makes sense. You subtract all costs you incurred; you come up with the bottom line (officially known as “net”) profit – and this is what you pay taxes on. I would even suggest that it is fair: you pay taxes only on the money that you did, in fact, add to your bank account, as a result of a successful real estate flip.

As you probably noticed, I made my example too simple, for the sake of clarity. Specifically, I ignored what we call business overhead: driving, computers, subscriptions, dues, office supplies, cell phones etc. All of that stuff is indeed tax-deductible, but let’s take it out of our discussion, to keep things simple. Another simplification was that my example used cash, and cash only. Nowadays, it is a long shot.

Next, we need to look into two related issues: what happens when you use borrowed money instead of cash, and how much taxes you pay on this $20,000 profit.

2. How much taxes?

I wish I could give you a good short answer, but there’s none. As a matter of fact, this opens up an entirely new (and very complex!) topic that falls outside the scope of this article. We only have time to scratch the surface of it, so let us scratch.

The IRS recognizes only two kinds of investment properties: rental properties and resale properties. Rental properties are those that you plan to hold for a relatively long time, making money in two ways: from monthly cash flow (rent minus expenses) and from appreciation (property value climbing up with time). In one word, you make money by waiting.

In contrast, resale properties are those that you’re trying to get rid of, as soon as possible and as high as possible. Besides your holding period being relatively short, your business model is very different. In resale situation, you profit from price spread (buying low and selling high) and from improvements (rehab and repairs to quickly increase the value of the property). In one word, you make money by working.

The problem is that this seemingly simple distinction does not fit our business. We, as real estate investors, frequently do not know our plans and exit strategies up front. We may get into a deal simply because it’s a good deal. Only later we decide whether we want to flip this property or keep it as a rental. Too bad the IRS does not understand this business reality. Until they do (which, of course, will never happen) – we must label each property we buy as either rental or resale. No such thing as “wait and see” for the IRS – only rentals and resales (also known as flips, and also known as dealer properties)

Why this distinction is important? Because tax rules are drastically different between rentals and flips, especially when it comes to selling. When you sell a rental property, your profit is “capital gain”which could be short-term (under 1 yr) or long-term (over 1 year). Short-term gain is taxed at your regular (“ordinary”) tax rate, whatever it is – typically 25% for families with “decent” regular income. Long-term gain is taxed much lower: 15% or even less. Warning: beginning in 2013, the maximum rate went up to 20% for so-called high-income taxpayers – those whose taxable income is above $400,000 ($450,000 for married couples.)

The bad news is that profit from flip properties is not capital gain at all – it is “ordinary business income.” Not only is it taxed at ordinary rate (let’s say 25%), but it is also subject to an additional 15% tax, known as self-employment or Social Security tax. Together, the two taxes combine for the whooping 40%! There is quite a difference between 15% tax and 40% tax, agree?

Sometimes, it is quite clear whether your property is a rental or a flip/resale. In our auction rehab example, it was certainly a resale property. As a result, your $20,000 profit will cost you as much as $8,000 in taxes. Ouch. Better be ready!

In other cases, the distinction is blurry. What about property bought as a rental, staying vacant for long time and finally sold 2 years later without ever being rented? What about a flip that was temporarily rented for 6 months while being listed for sale? What about all the countless variations of lease-options and other creative selling techniques? Maybe it’s self-serving, but I do suggest you ask a real estate accountant. Mistakes in this area can be very costly. Remember – it’s a 15% vs. 40% question.

We have addressed the second and the third of the three questions I mentioned in the opening. Time to tackle the remaining one, about mortgages.

3. Mortgages and other financing: it is actually simple.

Yes, I said – simple. We humans just love to confuse things and make our lives more stressful than they ought to be. (How else can one explain the establishment of the IRS, FEMA and HCAD?) When we deal with mortgages, hard money, and all other loans, it is very easy to get awfully confused if we start thinking about all these advances, draws, and payoffs. What is simple about all that mess?

Nothing. However, there is a simple solution: for the IRS calculations, ignore all financing, period. Yes, that’s what I propose: just ignore financing. Think cash instead.

When you buy a property, forget that you obtained a mortgage. Write numbers down as if you paid full price in cash. When you sell this property, forget that you had to pay off that mortgage. Write down the numbers as if you received full price in cash. You still subtract all other costs like we did in the previous example. All except mortgage payments and payoffs. Pretend that you did everything in cash. Simple enough?

You may be wondering: would not it mess up the result? If I ignore mortgages, would not it show more taxable profit than I really made? Let’s look into this. Mortgages and other loans are borrowed money: whatever you borrowed, you will have to return. (At least, this used to be the idea behind borrowing, but I’m no longer sure.) You took money temporarily, and you paid back 100% of it eventually. It should be a wash, if not for two major “extras”: interest and closing costs. Interest and loan-related closing costs (points, origination, lender fees, appraisals, credit reports etc.) is what you pay over and above the loan principal. These are your additional costs.

No problem: you are allowed to subtract these costs from your net profit. Let’s be clear: we’re subtracting two things only: closing costs related to the loan and interest. Not mortgage payments, just the interest portion. Everything else we ignore – which includes down payment, regular payments, and payoff.

Once again, the simple (and proper!) approach is to do all profit calculations as if no financing existed. Then, subtract from the resulting number lender’s fees (which you can find on HUD-1 statement) and interest (which you can find on lender’s form 1098). That’s it, folks!

4. Long and winding… example

Disclaimer: the following example is boring. If you can’t stand calculators, skip this section and go straight to section 5.

For those who ignored my warning, let’s swim ahead. The true goal of this example is to justify why we accountants charge so much. Other than that honorable objective, I want to dispel a very common suspicion that the tax calculations are somehow unfair to real estate investors. (I happen to think they are just as unfair to everybody else, but at least they are sort of logical and mostly consistent.)

One more warning: this example ignores depreciation, but we will talk about depreciation later.

You buy a property for $95,000 plus $5,000 in closing costs – for the total of $100,000. You put down $10,000 and get a $90,000 temporary loan. The property requires $20,000 in repairs – which you put on your credit cards. After upgrade, the property appraises better, and you obtain a permanent mortgage for $110,000, paying off the temporary loan and credit cards.

For the next five years, the property is rented out. Let’s simplify and say that you broke even every year – zero cash flow. By now, the area became popular due to new developments, and property values shot up. You refinance with the new mortgage for $150,000 – essentially pulling out some equity in cash.

Next year, your tenant offers to buy it from you for $185,000 – and you decide to take the money. From $185,000 you first subtract $15,000 commissions and closing, leaving you $170,000. Of that, $150,000 will pay off the mortgage, so you walk away from closing with a $20,000 check. 15% capital gains tax on $20,000 is $3,000 – so you will still have $17,000 left for a down payment on your next property. Or maybe we can subtract the original $10,000 down payment from $20,000 – and cut taxes in half, down to $1,500? Not too bad, right?

Wrong. Your capital gain is $50,000, not $10,000 and not $20,000. Even at 15% rate, this creates $7,500 capital gains tax – almost half of your $20,000 check from closing! How did it happen?

Let’s apply my “forget financing” method. Your purchase price was $100,000 with closing costs included. Down payment and temporary loan do not matter. Rehab costs were $20,000 – and we ignore credit cards financing. We also ignore the permanent loan and subsequent refinancing. All we have now is $120,000 total cost. At sale, you received $170,000 (after subtracting commissions and closing), and we ignore loan payoff. The difference between $170,000 received and $120,000 cost is $50,000 capital gain.

You have to agree that my method (actually, it is the IRS method) is simple. But is it fair? Let’s trace cash carefully. You originally put $10,000 in as a down payment, plus $20,000 on credit card. When you got $110,000 permanent loan, it paid off credit card, so your only cash investment at this point is $10,000 down payment.

What is easy to forget is that you refinanced with a $150,000 loan. It paid off the old $110,000 loan and gave you $40,000 in cash. From this cash, you “paid back” your $10,000 down payment, and the rest was yours to keep. This was $30,000 of cash profit that you never paid taxes on! Never – until now. $30,000 untaxed profit from that cash-out refinance plus $20,000 at sale = $50,000. This is what you really made on your property, all things considered – and this is what the IRS will treat as a taxable capital gain.

You may think that $7,500 of tax is outrageous when your closing check is just $20,000 – however, remember that you really made $50,000 over the time you owned this property. What if you absolutely hate paying $7,500? Well, there is always a tax planning opportunity known as “1031 exchange” or “like-kind exchange.” If you never heard of it – ask.

5. “Depreciation recapture” trap

In the example we just finished, the investor walks away from closing with a $20,000 check. From this windfall, $7,500 will go to Uncle Sam as capital gain tax, and it stinks. In fact, it gets much worse. The investor will also owe another little-known tax: depreciation recapture of roughly $5,000. After paying the entire tax bill, there is not enough cash left for the next down payment! Now, this is what I call a problem.

To prevent problems like this, take time to sit down with a good tax accountant before (not after!) you sell a property. Meanwhile, please read this introduction to depreciation recapture.

6. Take-home points

Let us quickly review what we discussed:

• Taxable profit is “net” profit after all costs are subtracted.
• Ignore financing for tax calculations, except for interest and fees.
• There is a big difference between rental properties and flip/resale properties.
• Taxes from sale of flips are very high: ordinary rates plus self-employment tax.
• Taxes from sale of rentals are much better: capital gain rates.
• Capital gain taxes can be avoided or delayed with proper tax planning.

Have fun investing, and do not let the IRS ruin your fun. We accountants are here to help.