Taxes... L/O Versus Rent
As I attempt to become more tax savvy (it is a long road, btw), I am starting to question my exit strategies for purchasing properties subject to. My original plan was to purchase using the sunject to method and then L/O the property, and further to use the down payments received on additional investments.
If the IRS has definitively different definitions for investment use and dealer disposition, and the L/O falls in the disposition category, which then means I am taxed on it at the same rate as my earned income, plus state and federal...why in the world would I want to do the L/O as opposed to holding for a year minimum? It seems as though there are many people that purchase subject to and then L/O the property out (which I was planning on doing) but the tax burden is HEAVY isn't it? Having it in the disposition category also prevents it from being eligible to participate in a 1031 tax exchange, correct?
Seems as though I need to re-think my plan of purchasing sub-to and then L/O the property out. This hinders my ability to use the decent down payments I take in, towards other REI ventures. Will I simply have to bite the bullet for a year to be able to get additional cash for other investments?
Thanks in advance.
Suntzu18
You have none of your money invested in the deal (Subject To) and you collect an option consideration, monthly cash flow, and a backend profit.
Many would consider that they came out way ahead even after giving half of their profit to the IRS. If you can do it 10 times a year (year after year), your after tax income will still rival the average salaried worker's take home in a year with a lot less effort expended.
You're talking about flipping the property, for a $40K profit, right? You will be taxed on the $40K profit. This is considered earned income subject to SE taxes, so you will pay income taxes, as well as SE taxes. I don't know anything about Ohio state taxes, but ballpark federal taxes at 30%, plus the 15.3% SE tax, and your tax hit would be about $18,000, leaving you an after tax profit of approx. $22,000. "Ballparked"
You should look into using an S-Corp for this type of investing. This would eliminate the SE tax, although the S-Corp may have to pay you a salary, so you would still be subject to some FICA, but not on the whole $40K. Would be glad to go into this, however if you try searching for an article written by I believe Myfrogger, it may clear up any issues you have.
This of it this way (to really keep it simple).
If you earn money short term (less then a year from when you buy to when you sell), it is like getting a raise at work for the same amount as your profit. There is actually a difference or two but this will crudely get you to an estimate. What even the money would have been taxed at work you will get hit with (plus slightly more for the employer side of the FICA).
If you hold the property for a year then you pay capital gains (long term investment).
Similar more or less when figuring the state taxes.
Though you might not like paying the tax consider it a sign that you did well and made a profit.
If you want to do some tax planning to reduce the bite, do a deal and make a profit. Take some of the profits to a good accountant/tax attorney. Then do the second deal smarter with professional advisors keeping you on the correct side of the rules.
If you have spare cash laying around you can pay for the advice before the first deal rather then using the profits from the first deal to self-fund the advice.
John
[addsig]
On the other hand, if it's a rental and held over a year, Federal tax is 15% or less, no SE tax.
How long will you hold the property? Will it be a rental? If not, will you make improvements? Will you live in it?
Thanks for all the replies!
I first thought of just selling the property right away, but the guy currently living in the house cut me a rent check last week for $10K covering the month of Oct when the court was holding my money as well as Nov, Dec, Jan, & Feb.
I was shocked when he came up with this money so quickly after getting foreclosed on. He says he wants to keep renting, and I guess it would be in me best interests to let him keep doing this. He will also let me show the house to potential buyers when the time comes. After mortgage, ins, etc I am clearing $600/month.
So, if I rent this out for over a year, I clear some nice $$ each month, and when I go to sell, I will be taxed on a much smaller percentage.
Are there any downsides to this deal. I don't see any. I will probably continue to rent to this guy.
Gusty
A properly structured 1031 exchange will allow you to defer all your capital gains until your replacement property is sold in a taxable transaction.
Whether the LLC owns the rental property or you own it in your own name, your tax liability will be unchanged.
It would not be wise to hold in your personal name. If you're already in an LLC, and it sounds like you're gonna hold for over a year, you're in the right entity. I hope you realize that the 30% federal tax I spoke about was only an estimation, I have no way of knowing what tax bracket you fall into...
If you own the propery in an S-Corp, the S-Corp's earnings are not subject to SE tax.
rentalman,
If you are flipping property (the investment strategy that started this thread) in your S-Corp, you certainly do have a self-employment income tax issue to consider.
True, S corp earnings technically aren't subject to SE tax, but if you provide considerable services to the S corp without it paying you a salary (which is subject to SE taxes) you're taking a risk.
Sounds like it has already been converted to a rental. You don't necessarily have to rent it for a year, only hold it for a year, but the longer you rent it, the more it shows that you intended it to be a rental (which would make it capital gain at a lower rate)