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No. of Recommendations: 3
Original price $1mm
+ Improvements $200K
- $100K depreciation
= $1.1mm Basis?
Sales price = $1.5mm
Difference = $400K


Let me point out that the recapture of the $100k in depreciation will be recaptured, which is taxed as ordinary income, not as capital gains.

So when I sell I pocket $400K which I pay capital gains on.

So, there are two issues with this statement:
1) As pointed out above, depreciation recapture is taxed at ordinary income rates, not as capital gains. So, yes, that $100k is taxable, but it's not taxable at capital gains rates.
2) We don't know how much you owe on your mortgage(s). Unless your indebtedness plus the costs to sell were exactly the same as the basis of $1.1MM, what you get in your pocket will be different than $400k. What you get in your pocket will be the sales price, minus any indebtedness (like your refinanced mortgage), minus any costs to sell (like commissions, recording costs, title insurance, etc.).

Again using the example above: what you’re saying is if I’ve refinanced multiple times and had taken out $400K cash and when I sell I won’t have any cash to pay the taxes on the $400K gain. Correct?

Incorrect. In fact, if you had started out with a $1.2MM mortgage, and refinanced enough that you had taken $400k in cash out, so that your indebtedness ends up being $1.6MM, you would have to bring money to the closing table to pay the extra $100k you owed plus any selling costs. But you would still owe taxes on the $400k. That's the risk in taking cash out mortgages on property.

AJ
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No. of Recommendations: 7
I’m trying to understand how the cash taken out on cash-out refinance is taxed (or not) when the property is sold.

It's not. The cash taken out is irrelevant for tax purposes.

For example, I invested $50K into a rental property over a decade ago.

Irrelevant. What is important is the price paid for the rental property, not the cash invested.

I refinanced a few years and I took out $75K cash.

That doesn't matter.

Say if I sell it now and make a gain of $100K, I understand that I have to pay capital gains on that.

The gain is the difference between the sale price and your basis in the property. Since this is a rental, your basis is the original purchase price plus purchases costs, add in any improvements made over the years, and subtract off the depreciation that you took, or should have taken, on the property. Cash invested, cash out refinances, and cash proceeds from the sale don't enter into the picture.

How does the $75K cash that I had taken out play into it and how (if it is) is it taxed?

It doesn't enter the picture.

The upshot of all of this is that it is quite possible that your cash out refinances can leave you without enough cash after the sale to pay the taxes due on the sale. That can be a very uncomfortable position to be in.

--Peter
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Thank you Peter for your response.

So if I understand you correctly, in the following example:?
Original price $1mm
+ Improvements $200K
- $100K depreciation
= $1.1mm Basis?
Sales price = $1.5mm
Difference = $400K

So when I sell I pocket $400K which I pay capital gains on.
But when I refinanced, say I took out $75K and used it for a different investment (not an improvement on the same property). Was this $75K get absorbed in the terms of refinance or what am I missing as it looks like free money? I would think the $75K it is reduced from the $400K.

The upshot of all of this is that it is quite possible that your cash out refinances can leave you without enough cash after the sale to pay the taxes due on the sale. That can be a very uncomfortable position to be in.

Again using the example above: what you’re saying is if I’ve refinanced multiple times and had taken out $400K cash and when I sell I won’t have any cash to pay the taxes on the $400K gain. Correct?

Thanks again.

- Colin
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No. of Recommendations: 1
Paco1985 writes (in part):

So if I understand you correctly, in the following example:?
Original price $1mm
+ Improvements $200K
- $100K depreciation
= $1.1mm Basis?
Sales price = $1.5mm
Difference = $400K

So when I sell I pocket $400K which I pay capital gains on.


I reply:

Your conclusion here is not correct. You would pay capital gains on $300k in profit. You would pay taxes on $100k as recaptured depreciation, which is taxed at a higher rate than capital gains -- last time I was paying attention (which was several years ago) that rate was 25%.

And in case you get the bright idea of refusing to take the depreciation, that wouldn't help. You pay this rate on depreciation "allowed or allowable," which means that you pay the higher rate whether you actually claim the depreciation or not. So you may as well claim it.

At those numbers, by the way, you'll also be subject to the 3.9% tax on investment income imposed by the Affordable Care Act on at least part of the gain. --Bob
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No. of Recommendations: 4
So if I understand you correctly, in the following example:?
Original price $1mm
+ Improvements $200K
- $100K depreciation
= $1.1mm Basis?
Sales price = $1.5mm
Difference = $400K

So when I sell I pocket $400K which I pay capital gains on.


Yes. Well, sort of. With that info, you do have a $400k gain that you'll pay tax on. (Bob got into some of the gory details, which aren't important at the moment.)

But I have no idea what you'll pocket. The cash in your pocket depends on what the mortgage balance is. And that figure isn't in your example. It doesn't need to be because it doesn't affect the taxable gain.

But when I refinanced, say I took out $75K and used it for a different investment (not an improvement on the same property). Was this $75K get absorbed in the terms of refinance or what am I missing as it looks like free money? I would think the $75K it is reduced from the $400K.

OK. Let's extend the example a bit. We'll use your numbers from above, so we already know the taxable gain. That's because mortgage activity doesn't enter the picture when calculating taxable gain or loss. But it does affect your cash flows.

Let's add in a mortgage and a refinance.
We'll use an $800k loan with the purchase, so a $200k down payment. Then we'll do a refinance for $875k to give you the $75k cash out.

Shen you sell, you'll need to pay off the current mortgage. Here's what we've got:
Sale price $1.5 million
- mortgage payoff $875k
= cash proceeds from sale $625.

What did you put in and take out? I'll use the standard cash flow notation, with cash out of your pocket as negative numbers and cash into your pocket as positive numbers
- Down payment $200k
- improvements $200k
+ cash out refi $75k
+ sale proceeds $625K
= net cash inflow $300k

"Wait a moment," you might say. "That doesn't match my taxable gain?" Quite right. The difference is the depreciation taken. (And now Bob's comments come into play.) While you own the property, you've been taking depreciation. That's a deduction for tax purposes. It's writing off part of your original purchase. Basically, it's a tax deduction that didn't require you to spend cash. (Well, except for the purchase of the property, of course.)

In the end, the $75k from the cash out refi is not free money. It's simply an early return of your original investment - or potentially and early portion of your profits.

--Peter
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No. of Recommendations: 3
Original price $1mm
+ Improvements $200K
- $100K depreciation
= $1.1mm Basis?
Sales price = $1.5mm
Difference = $400K


Let me point out that the recapture of the $100k in depreciation will be recaptured, which is taxed as ordinary income, not as capital gains.

So when I sell I pocket $400K which I pay capital gains on.

So, there are two issues with this statement:
1) As pointed out above, depreciation recapture is taxed at ordinary income rates, not as capital gains. So, yes, that $100k is taxable, but it's not taxable at capital gains rates.
2) We don't know how much you owe on your mortgage(s). Unless your indebtedness plus the costs to sell were exactly the same as the basis of $1.1MM, what you get in your pocket will be different than $400k. What you get in your pocket will be the sales price, minus any indebtedness (like your refinanced mortgage), minus any costs to sell (like commissions, recording costs, title insurance, etc.).

Again using the example above: what you’re saying is if I’ve refinanced multiple times and had taken out $400K cash and when I sell I won’t have any cash to pay the taxes on the $400K gain. Correct?

Incorrect. In fact, if you had started out with a $1.2MM mortgage, and refinanced enough that you had taken $400k in cash out, so that your indebtedness ends up being $1.6MM, you would have to bring money to the closing table to pay the extra $100k you owed plus any selling costs. But you would still owe taxes on the $400k. That's the risk in taking cash out mortgages on property.

AJ
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No. of Recommendations: 0
aj485 writes (in part):

Let me point out that the recapture of the $100k in depreciation will be recaptured, which is taxed as ordinary income, not as capital gains.

I reply:

Isn't the federal tax rate on recaptured depreciation capped at 25%? --Bob
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Isn't the federal tax rate on recaptured depreciation capped at 25%? --Bob

Isn't the recaptured depreciation taxed as regular income for non-real estate with the 25% rate cap only for real estate?
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vkg writes:

Isn't the recaptured depreciation taxed as regular income for non-real estate with the 25% rate cap only for real estate?

I reply:

I don't know the answer to your question, but in this case we're talking about real estate. --Bob
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Isn't the recaptured depreciation taxed as regular income for non-real estate with the 25% rate cap only for real estate?
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That's correct.

Bill
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