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Taxes on sold house

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.

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.

20 Responses to Taxes on sold house

  1. Sharon Davis September 10, 2013 at 11:02 am #

    Dear Sir, I had a relative pass away 4 months ago and I am his only living family. I want to sell his house, and have asking price of 40,000. and i want to sell it myself so I don’t have to pay all the fees a Realtor would want. Will I have to pay a capital Gains tax on the $40,000. I have had a yes and no answer so i need varification . Thank you for your reply

    • admin September 29, 2013 at 11:31 pm #

      Thank you for asking, Sharon.
      If this house became yours by inheritance, you’re considered to have acquired it for its current market price, which is $40,000, according to your statement. When you sell it, you will actually have a small LOSS, equal to your closing costs and selling expenses. In other words, your taxes may go slightly down, not up.
      Michael Plaks
      See disclaimers

  2. John September 12, 2013 at 12:43 am #

    What about refinancing to buy out partner/co-owner at the higher appraised value? Is capital gains based on this new value which was used in securing funds or the original cost of the property? Example: Property originally purchased for $10k by husband and wife. Marriage ends and husband buys out wife’s interest based on the updated (since a significant amount of time has passed) and higher appraised value of 15k. More time passes and Now the land is sold for 20k. Is CG $5k or $10k?

    • admin September 29, 2013 at 10:04 am #

      Thank you for asking, John.
      This situation can be tricky, and it is affected by local law, especially in so-called community property states. I will give you one possible calculation, but it’s not necessarily accurate in your particular case. So they bought it for $10,000. When it’s worth $15,000, husband buys out his ex-wife for half the value – $7,500. After that, his investment (basis) in the property will be 1/2 of the original purchase ($5,000) plus the buyout of $7,500, for the total of $12,500. When he sells it for $20,000, his capital gain is $20,000 – $12,500 = $7,500.
      Once again, there could be complications that change the result. Michael Plaks.
      See disclaimers

  3. Brandon December 9, 2013 at 7:28 pm #

    Last year I purchased a 19 acre lot of vacant of land surrounding my main home. Appraised for $52k which I paid 40k for with a loan financed at 32k. The owner of a larger parcel behind me is donating his property to the local nature center. The land would be land locked for access for the nature center, the owner has offered $8k to buy a 50 ft slip from the road along the east side of this property to allow access to his property he is donating. My question is what if any taxes I would have to pay for this transaction.

    • admin December 27, 2013 at 3:14 am #

      Brandon, your explanation is somewhat confusing to me. If I understood you correctly, you will receive $8k to surrender a narrow strip of land that now belongs to you. If so, then it is a taxable sale. You will have to allocate part of your purchase price ($40k) to that strip of land, probably using its size to figure the ratio. In other words, if the size of the strip is 5% of the 19 acres total, then you paid $2k (figured as 5% of $40k) for the strip. You will have a capital gain of $6k ($8k minus $2k). It could be long-term capital gain (no more than 15%) if it has been 1 year since your purchase. Otherwise, it’s short-term capital gain, which can be twice as much as long-term. Hope this help.
      By the way, have you considered leasing this access land instead of selling it? Michael Plaks
      See disclaimers

  4. Cindy Moss January 16, 2014 at 11:56 pm #

    Dear Sir, I purchaced a 40 acre vacant piec of land in 1984 for hunting ect and recreational use. It is not zoned recreational. I sold this property in Decemebr 2013 and wonder if I have to pay capital gains? Can you give me your thoughts?

    • admin January 27, 2014 at 7:12 am #

      Yes, Cindy, you will have to pay long-term capital gain tax (up to 15%) on the difference between what you sold this land for in 2013 and what you paid for it in 1984. You can only subtract closing costs and cost of improvements you made to this land, if any. Possibly you may be able to subtract property taxes if you have not been deducting them every year. Michael Plaks.
      See disclaimers

  5. TIffany January 17, 2014 at 9:23 am #

    We bought a house in 2006 lived in it 2 years, then moved for grad school (we intended on going back, but moved away instead). We rented it out from 2008-2013 and it’s been vacant 3 months now. We paid 160k for it, we’ve put in custom blinds ($1700), added a deck ($1500) and a new roof ($8000) since we bought it. Now we are trying to sell it, but with the market the way it is we can only hope to sell it for around $175k (positive estimate). Over the years we’ve claimed about$18000 in depreciation on it.

    Will we have anything left after Capitol gain taxes? (I tried to figure it out but I’m still confused.) Can we deduct the cost to sell the thing from our capitol gains taxes? We were hoping to use our profit to purchase a primary residence in the state we live in now, but after doing a little research on capitol gains taxes, I’m not sure that will be possible.

    Thanks for any insight you can give.

    • admin January 27, 2014 at 7:06 am #

      from your numbers, it does not look like you will have capital gain taxes except for so-called depreciation recapture. This depreciation recapture, in the worst case scenario, will be 25% of your $18k – or approximately $4k, maybe less. So, when you estimate your numbers, subtract $4k for taxes from the money you expect to receive from the sale. Hope this helps. Thank you for asking! Michael Plaks
      See disclaimers

  6. Jimmy May 7, 2014 at 5:59 pm #

    Hello! My step mother (widow) is about to sell home for 115K and the house is paid for. She has lived in the house for 20 years. What taxes will she owe if any? If she puts in IRA, would this be the smartest move for her?

    • admin May 8, 2014 at 5:35 am #

      Jimmy, if your stepmother lived in this house for 20 years and still lives there, there will be no tax when she sells. Thanks for asking. Michael Plaks.
      See disclaimers.

  7. Dante Savan May 7, 2014 at 11:28 pm #

    Dear Michael: I bought an apartment building I 1976 for $ 195.000.Planing to sale at 1.900.000;how much will be the capital gain aprox.thank you

    • admin May 8, 2014 at 5:29 am #

      Dante, your capital gain tax will be 15% of the $1,900,000 – almost $300,000. Congratulations on a good investment, but you need to talk to a good accountant, not look for answers online. Too much money at stake. Here is my article about capital gains, to give you a start. Let us know if we can help. Michael Plaks.
      See disclaimers

  8. Jim Hamrick May 17, 2014 at 5:28 pm #

    My wife and I bought property in 2001 to retire to or bulid a vacation home after I finished working in another area. We purchased it for $29,000, added a completed 2 car garage, electric and water to the property. We have been paying higher rate property taxes for a vacation /rental. After my wife had a major accident, we knew we could not build on this property and attempt to do most of the work ourselves. We placed it up for sale and have a potencial buyer for $55,000. We would like to buy a place in Florida. Can this be considered a like exchange?

    • admin May 26, 2014 at 1:56 am #

      Jim, in order to qualify for a like-kind exchange (aka 1031 exchange), both properties will need to be “investment” or “business” properties. And while your old one may possibly qualify as an investment property, your new one in Florida will not. However, your capital gain taxes on the sale are going to be modest, so no reason to despair. Good luck with your retirement and your wife’s recovery. Michael Plaks.
      See disclaimers

  9. Katina May 20, 2014 at 9:26 pm #

    I am pretty sure I know the answer, but I just want to clarify. I bought a building about 4 years ago for $175k we are selling it for $160k. We occupied the building with our own business. Because the net is going to be a loss, will there be any tax on that loss?

    • admin May 26, 2014 at 1:23 am #

      Thank you for asking, Katina.
      You are unlikely to have any tax, but it is still possible to have a little bit. From your initial cost of $175k, you have to subtract depreciation taken over 4 years, and it will bring your actual “tax basis” to a little below $160k. This may result in a small taxable gain on the sale, but it’s unlikely, considering closing costs. Michael Plaks.
      See disclaimers

  10. Jane May 23, 2014 at 7:36 pm #

    Hello, I built a house 7 years ago before I become resident of California. Also, I haven’t live in it the last 4years. I would like to sell the house.
    My house is in Europe (Never rented.). I have to pay 20% capital gain tax in my country.
    Do I have to pay additional federal tax in the USA and California income tax if it is only one property I have?
    Can I sell my house in Europe and buy a house in California and don’t pay capital gain tax?

    Thank you!

    • admin May 26, 2014 at 2:10 am #

      Thank you for asking. You will still owe US capital gain tax, because US citizens and residents pay taxes on their worldwide income. However, there’s a “foreign tax credit” on the US tax return that is designed to offset the taxes that you will owe to your country and avoid double taxation. Buying a house in California will not change this tax situation. Michael Plaks
      See disclaimers

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