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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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