Taxed On Profit Or On Sale?

I know this is probably the dumbest question ever:

If I purchased 5 apartments at $285,000 and fix up to sell at $350,000, would I pay 15% tax on the difference which is $65,000 since that is technically my profit, or would I pay 15% of the whole $350,000?

P.S. I just purchased this property a few months ago.

I'm thinking that this rental thing is not for me. I just contracted a property management company, but they say people disregard once they're told a credit report will be run on them.

Any ideas of how I should proceed so I loose the least amount of money?

Thanks,
Ruby

Correct me if I am wrong, but you get the full wallup, on the profit only...Full federal, State and Fica (15%)Tax. Quick turn will set you up as a "dealer" status, and the property will be treated like inventory.You only get 15% federal+ x% state(if applicable in your state) in a long term capital gains situation, like over 1 year. Buy, fix and rent, then sell 1 year later, capital gain. Buy, fix, quick turn , dealer status and the whole nut.
I would consult a accountant to verify the above to make sure you don't make any errors. Better to pay a little bit for advise than pay a lot later...to the Gov.

[ Edited by whitebb on Date 08/28/2007 ]

For a fix and flip you will indeed pay SE tax (social security tax and medicare tax), income tax at your rate, and any state and local taxes. This will be on the $65,000 profit, not on the entire sale amount. The price of the property and your rehab costs are considered the basis, and your holding costs are deductable. Tax will be on the profit, after all expenses, in this (or any other) situation.

As was previously mentioned, if you rent it out for a year or more before selling your profit will get long term capital gains tax treatment, meaning that instead of SE tax plus your regular income bracket tax, you will pay a maximum of 15% in long term capital gains taxes on your profit, and most likely less on some portion of the profit unless you are in a higher income tax bracket (the portion that falls within the 15% or less bracket will not be taxed!).

My advice would be to get some tenants in there and hold it for the year, then if it is still seeming like a big problem to you put it on the market. A fully rented building is more valuable than an empty one in any case. Use incentives if you have to- a month's free rent at the end of a year's lease, reduced security deposit for a lower move in cost, free utilities, whatever it takes to get good renters in there. Better than having the place sit empty! If you sell it now the government is going to take half your profit in taxes.

Of course, if there is no profit then that is not an issue...

Chris

If you have made a sincere effort to rent the units and just could not make a go of it, then rehabbing may make the units more attractive to renters and generate a market rate rental income. If all your efforts to rent the units fail, then selling may be your best opportunity to still profit.

If your holding period is one year or less, the short term capital gains tax rate is the same as your ordinary income tax rate. Self employment income tax will not apply in this situation.

If the holding period is more than one year, then the maximum 15% capital gains tax rate applies.

[ Edited by NewKidInTown3 on Date 08/28/2007 ]

Newkid,

Is this ( no SE tax) because of the "sincere effort to rent"? The intent was to hold rather than flip?

As always I appreciate and respect your input on these matters-

Chris

From the scenario presented in Ruby's post, I am led to believe that the primary reason for the purchase was to hold for the production of income. Ruby has completed repair/rehab and has recently contracted a property management company. Ruby now appears to be discouraged by the lack of tenant applications.

While she does not say, I am guessing that she can't pay the holding costs very long without any offsetting rental income and, facing a discouraging rental picture, is now considering a sale .

We don't know why the property management company can't get a qualified tenant in place. Perhaps the property is the problem, perhaps the location, perhaps a very soft rental market, or some combination of all the above.

Ruby told us that she is considering selling because this "rental thing" is not working out for her. Her question is how would her sale profit, if any, be taxed.

Since her opening statement asks "If I purchase... fix ... then sell", the casual observer will conclude that this is a dealer tax treatment situation. Maybe I am reading too much between the lines, and see her question in a little different light. In her situation, I would argue that she has an investment property that has gone sour due to market forces and bad timing. If my interpretation of her question is correct, then capital gains tax treatment applies in this case, not the dealer tax treatment.



[ Edited by NewKidInTown3 on Date 08/28/2007 ]

We already started rehabbing the apartments. All the apartments got tile on kitchen countertop, and shower. Additionally, 2 apartments also got tile floor in the living room. Also, 1 apartment also got tile in bathroom floor.

I tried to rent myself and received a lot of calls (from about 35 people). It was hard to get an application to them since they didn't have access to a fax or email. At that time they were currently rehabbing and several people would be able to see the apartment from the inside. They said, "it's clean and tidy", "It's cute". I even got calls from nurses claiming they could pay and if I met them I was going to "love them". I made appointments with different people and they didn't show up. Usually all these people told me they needed a place ASAP. Later, when I told the property management company this- they told me they don't rent to people who come saying they need a place ASAP. When the property management saw the apartment she told me that I could probably rent them for $100 more than what I am currently renting. She was going to try and get Section 8 people in there.

There are 2 vacant apartments; another one will be vacant once the gentleman gets into a senior center, which he applied for a long time ago. Another tenant told me this was her last month, but the property management tells me they don't think she'll move out (She knows her personally, coincidently). So at the end I only have one for sure tenant (I hope). The problem was that they were renting at $300 and I increased to $550, but I had too. They were paying a rent rate from 6 years ago. I thought they were going to appreciate the rehabbing on their apartments, but I guess that wasn't the outcome.

Newkid, if I'm understanding correctly: I might be able to prove that I bought these with the intention of renting. So you're thinking that I might be able to get away with the 15% because of this without having to wait a year to pass, right?


Regards,
Ruby

[ Edited by rubyarias on Date 08/28/2007 ]

Not necessarily 15%; short term capital gains would be taxed as regular income in whatever bracket the income would put you into.

That's what I have learned from newkid, anyway, and when I reseach his statements I find he is almost always right-

Chris

Chris,

So I'm wrong? What you had stated on your 1st reply is correct and there is no special treatment for having "intent to hold"?

Regards,
Ruby

"Special treatment" is no SE tax- that is a more than 18% savings...

Chris

You guys are awesome! Thanks.

If your holding period is one year or less, the short term capital gains tax rate is the same as your ordinary income tax rate. Self employment income tax will not apply in this situation.

If the holding period is more than one year, then the maximum 15% capital gains tax rate applies.

I ran into this situation a few years ago where I had the intent to rent back to the people who sold me a house. It appeared that this might not happen and I did not particularly wish to hold a property in that neighborhood. I contacted a qualified intermediary to see if the house would qualify for a 1031 exchange and was told that it would since my intent was to rent even though I collected no rent.

This might be a possibility for you if you can find a property that you are more comfortable with for holding and renting for a bit. This way the gain will be passed on to the new property(ies) and be treated as long term gain provided you hang onto the new property for a time. I am pretty sure that you would be allowed long term gain if the sum of the times for holding your 5 unit and replacement property(ies) exceeds one year.

As an aside, I almost always exchange properties in CA to avoid the CA witholding.

[ Edited by edmeyer on Date 08/28/2007 ]

2cents more--
1. Your gain will be selling price minus costs to sell minus costs to rehab (keeping good rcpts and records?) minus purchase price minus costs to purchase.
350K (guess/hope) - costs to sell - 285K - costs to purchase - rehab costs. **Maybe you won't make much money anyway.

2. You are clearly a landlord since your property has tenants. You will claim depreciation (and have to recapture) and income for the timeframe that you have owned it. (and deduct many costs to operate)

You still have to keep it for 1 year for long term treatment.
1031 is only viable IF you want to purchase more rental property, correct?

To me, it sounds like your management company is less than helpful in several ways.
It sounds like you must be near a hospital where you could rent quick and easy to nurses. Maybe you should handle the rental part. I have had several bad experiences recently from management companies, so they are NOT ALL Reliable.

[ Edited by rubyarias on Date 08/29/2007 ]

Tax avoidance is one thing, and a favorite subject here on TCI.

Tax evasion is an entirely different matter. What you tell the IRS is your business, but you shouldn't be discussing it on a public forum.

Chris

OOPS!

I thought I was talking about tax avoidance.

Thank you Chris.

Regards,
Ruby