Long Or Short Term Capital Gain?

A couple of years ago I started buying Tax Liens in Colorado. In a simplified nutshell the process is that you purchase a lien at auction and pay subsequent years taxes until the certificate is at least 3 years old. At that point you file for title and if the owner still fails to pay the taxes the treasurer issues you a deed. I have purchased about 60 liens since 2005 so I’ll probably wind up owning a couple.

My question deals with determining the capital gains when I sell the property. When does the holding period start? Would it be the date of the original certificate, the date I file for title or the date title is granted?

I would think it would be the date of the original investment, but I'm not sure. You might do better asking in the tax matters forum.

Chris

If the treasurer issues you a tax deed, I think you will have to go through a judicial foreclosure or a quiet title action to obtain warrantable title if the owner has not redeemed your tax lien. What does your attorney say about this?

Once you have the tax deed (or sheriff's deed), your holding period for the property starts. Your cost basis will be the cost of the tax lien and the cost of the foreclosure. Just my opinion.

What happens if the owner pays the back taxes? Does the property owner's redemption price automatically include any taxes you paid in subsequent years? With interest?


[ Edited by NewKidInTown3 on Date 12/13/2007 ]

The county actually issues a deed to the property, complete with Title insurance (at my expense). If the owner redeems the back taxes they do pay all taxes, interest and fees associated with the tax lien. I lose my premium bid. It’s interesting that after just 1 year in some counties I’m already in the black on paper 7 in others I’m still in the red after more than 2.

In lieu of a better answer I was planning on handing this the same as stock with different purchase dates. I would essentially have 3 dates, the initial auction and 2 years of additional taxes. By the time I have title the original auction and the next year would already be more than a year old and therefore long term. The last year of taxes would be only a few month and short term if I flip the property in short order. Rough math would then be that 1 third of the profit would be subject to short term capital gains taxes and 2 thirds to long term. I think I’m on firm ground if I treat redeemed properties the same. The principal I’m going on is the length of time the money is invested.

I intend to ask the IRS this question so that I have a written answer, but I want to be informed before I write them.

Thanks

Erik

Your holding period for the property does not start until you have the deed in hand (the day after the deed is executed, if you want to be precise). For the moment you only have a lien. If the lien is redeemed you never get the deed. Even though you own the lien now, you don't own the property until you foreclose on your lien.

I hope by "better answer" you really meant to say a more "authoritative answer from the IRS". If by "better answer" you really meant any answer that agreed with what you want to do however incorrect, then you really hurt my feelings.




[ Edited by NewKidInTown3 on Date 12/15/2007 ]

By better I meant better than my own potential solution of handling it like stock in a single company purchased on multiple dates, but sold at one time. I have had cases like this where a portion of my profit is subject to short term gain tax & the rest to long term.

My military background does cause me to lean to the more authoritative answer, backed up by written references. It’s amazing how answers change when you politely ask for a written response in addition to the verbal.

Your answers will definitely help me form my question to the IRS in a manner that might generate an intelligent and accurate answer. It just seems that gains on money invested for more than 4 years should be considered long term gains. I’m afraid that I’ll have to wait until this scenario actually becomes a reality so that I can add firm dates and dollar figures to my question.

Thanks again

Erik

can part of the gain be booked to the holding period of the lein, and invest in other leins?

Erik,

I suspect that you are equating the tax lien to an ownership interest in the property. The tax lien and the deed to the property are two different capital assets.

In general terms, let's say I want to borrow $1000 from you for one year. I agree to repay the loan in full with interest within 12 months. You agree to give me the loan, but you want something of value to hold in case something happens and I don't honor our agreement to repay the loan. The only thing I have of value that you will accept as collateral is my car. I need my car but I give you the next best thing -- I give you the title to my car to hold. If I don't repay the loan on time, then you take the title to the DMV and become the new owner of my car. If I won't surrender the car, then you have it repossessed.

A tax lien is really a loan that you made to the homeowner with his property as collateral for the loan. The loan is brokered by the county tax assessor or treasurer and the loan proceeds are applied to the delinquent property taxes owed by the homeowner. If the homeowner repays the loan with interest, you release the lien and the deed to the property stays in the homeowners name.

Since you can't physically hold the homeowner's property, you hold a tax lien instead as the collateral for your loan. At the end of the redemption period, if your lien has not been redeemed, you foreclose on your lien to gain title to the property. Your lien is extinguished by your foreclosure.

There is nothing that says you have to hold the lien until the redemption period expires. You can sell it on e-bay if you want. Since the tax lien is a capital asset, capital gains tax treatment applies to any sale profits as appropriate for your holding period.

Once the lien is foreclosed, the holding period for the property starts on the day after the treasurer issues the tax deed. The day the deed is transferred is the last day of ownership for the former owner. The day following the day the deed is executed is your first day of ownership and the first day of your holding period for the property.

New Kid,

I understand your logic. Obviously I’d like a different answer since this is the worst possible answer from a tax point. It means that I have to hold property for a year after receiving title, or pay the higher tax. This just doesn’t seem to follow the spirit of the tax break for long term gains. The earliest I can gain title to the liens I purchased in 2005 would be early to mid 2009. This means that investments that gain after 4.5 years would be subject to the short term tax rate.

Another application of a similar principal is a Contract for Deed more commonly known as a Land Contract. For the purpose of the holding time does the seller’s holding time extend to the end of the contract? If so, this is a way to sell properties gained through lien and legally avoid the higher tax rate. Another way might be to lease the property with an option to buy after a year.

I should mention that I started buying tax liens in November 2005 and currently own 43 liens in 3 different counties in Colorado. I will probably post a modest profit in interest for 2007, but with interest accruing at the rate of $400+ each month the tax implications are increasing.

Thanks

Erik

"Taxes are not the problem to focus on. Start working on making more money and quit worrying about the taxes."

While this is essentially good advice, it is still prudent to plan your transactions to bring yourself maximum gain, which often includes paying the minimum possible in taxes. If you were to offer your properties for rent as soon as you obtained the deeds, and not attempt to sell them for over a year, you would not only potentially collect substantial rental income but your properties would become eligible for long term capital gains treatment.

And who knows, that steady stream of rental income might convince you that you don't want to sell after all, or at least not before the tenant leaves!

Chris

I agree with the both the opinion that you only owe a lot of taxes if you’re making a lot of money, and the opinion that you should reduce the taxes as much as you legally can. I have no interest in owning rental properties as it simply does not fit our lifestyle. Currently we spend 3-4 months each winter in Mexico and hope to extend that to almost 6. We have purchased liens on a variety of property, but concentrate on vacant land. Since vacant mountain land just doesn’t sell when it’s under snow there isn’t any real market until late April or early May. Real Estate and tax lien investing suits us fairly well since the Colorado auctions are in October & November and I don’t need to be available to show properties I own in the winter.

Erik

When I was a kid I spent a summer with my grandmother in her cabin a couple miles north of Black Hawk. We had a mini blizzard on the fourth of July. So yes, summer is short up there...

Interestingly I also spent many of my winters as a child in Mexico. So I certainly understand the logic of your lifestyle!

Chris

"Taxes are not the problem to focus on. Start working on making more money and quit worrying about the taxes."

Was thinking along similar lines. But if the whole focus of this thread was to minimize taxes legally I'd like to offer up some tips:

Find and use a CPA who is familiar with tax liens and installment sales.

Try a couple installment sales when you are ready. Because you are taxed on only the year in which installments are collected, your gains can be spread out over as many years as you designate, say 15 years. (or more) True an installment sale done as a flip (meaning it's done within a year of owning said property) will require more tax, but over 15 years you may not really notice.

Start driving to and from your properties once they are deeded to you and get them sale ready. Mileage is deductable the year it occurs. I buy property under snow, others do too.

Get married, have children, pay mortgage interest on your own home and even a second home. (all optional of course!)

Don't forget to deduct everything else related to the further acquisition and sale of land -- those trips to Mexico included. (or a paid membership to TCI)

Nice work on the $400 plus a month interest. If one of your liens converts to deed and you sell in on terms, you might double that figure. Rinse and repeat - then you'll really have problems...

[quote]
Get married, have children, pay mortgage interest on your own home and even a second home.

Getting Married & having children to save on taxes seems like buying a 747 for the free penuts!

Hey newkid, your situation must have different variables. I don't know how to explain it, but I have done 'installment flips' and the IRS doesn't collect all up front like you say. Perhaps the difference is if you are a 'dealer' in their eyes or not.

I have read that a dealer has those impositions placed upon their financed transactions. How crass! Hopefully you're in the same rank as myself (common folk) and aren't speaking from experience.

Sounds like you're not into families- Well in any case, consider buying a home, since, if you live in it 2 years out of 5, when you sell it, it has a $250K exclusion over basis, and "flipping" is not an issue.

Interesting topic, but I don't think you'll have to worry about the differentiation after the election