Tax Treatment For Cash Out

What is the name of your state? PA

Two people purchase and fix up a house for cash (let's say $50,000), with one of the partners (A) putting up all of the money, including fixing it up, etc. They then go to a bank and partner B who put up $0 obtains a mortgage for $70,000 (because it appraises for $87,500 and has a tenant paying $1,000/month). Partner B gives Partner A the $70,000 and partner A signs over the deed to Partner B for $1. So, partner A has their original investment back plus $20,000. Partner B now has the property, a $70,000 mortgage, the rental income, and any increase in value when the property is sold.

Here's the question: For tax purposes, how is the $20,000 (over and above the original $50,000) treated on Partner A's federal tax return?

[abezon]

Partner A declares capital gains of $70,000 - $50,000 - whatever A spent fixing the place (save receipts). The money goes on a Schedule D as a long term (held over 1 year) or short term gain. Long term gains are taxed at a lower rate; short term gains are taxed like regular income.

UNLESS Partner A's business is buying run down houses and fixing them, then selling ASAP. Then Partner A puts the $70k on a Schedule C, and puts all the expenses ($50k + materials + mileage allowance) on Sch.C and pays regular taxes AND self-employment taxes on the profit. Note that the two profits will differ by the mileage allowance A takes on Sch.C.

Partner B has a basis for depreciation purposes of $70,000 + whatever closing costs the bank added to the purchase loan.

[JETX]

Your formula is incorrect.

Person A: Would have to pay capital gains on the full $70,000 (gained) less his 'cost basis' ($1.00). The prinicipal here is... he can't deduct the $50,000 borrowed since it wasn't a 'cost' and wasn't repaid, he just 'transferred' that debt to another (person B).

So, he would have to pay tax on $69,999.00. Depending on how long he (A) held the property, it could be short-term or long-term. Also, he would have to report any 'profits' from the rental income for the time that he held the property.

[abezon]

Originally posted by Halket
Your formula is incorrect.

Person A: Would have to pay capital gains on the full $70,000 (gained) less his 'cost basis' ($1.00). The prinicipal here is... he can't deduct the $50,000 borrowed since it wasn't a 'cost' and wasn't repaid, he just 'transferred' that debt to another (person B).

So, he would have to pay tax on $69,999.00. Depending on how long he (A) held the property, it could be short-term or long-term. Also, he would have to report any 'profits' from the rental income for the time that he held the property.

Halket, why do you think A's basis is $1? A put up the original $50,000 to buy the house and bought all the materials used in the repairs. A's adjusted cost basis is all the money A spent on the house and repairs. A's gain is at most $20,001.

[JETX]

My error.. for some reason I thought that he had BORROWED the $50,000 for the purchase. Of course you are correct and, if he provided the money in cash, then his 'cost basis' was $50,000 and he would only have a gain of $20,000 less costs of repairs.

Another example of my fingers taking on a life of their own and typing faster than my thought process!!

Partner B gives Partner A the $70,000 and partner A signs over the deed to Partner B for $1.

Can this be interpreted as two separate transactions with the following results:

1. Partner B has gifted $70,000 to partner A, hence must file a gift tax return (Form 709).

2. Partner A has a loss on rental property of $49,999 (50,000 - 1), which is reported on form 4797.

3. Partner B cost basis for property is $1.

[abezon]

No, it's a business deal and A has to declare gains. You'll never convince the IRS that A &B just happened to gift each other with a house and the fair market value of a house at the same time by coincidence. Also, why the heck would B want to do things this way? B's basis in the house would be $1 and B would get no depreciation and pay huge gains later.

I tend to agree with you, but the part that's bothering me is the deed for $1. What is the reason for that? What document or receipt substantiates the fact that partner A actually sold his interest in the property to partner B for $70,000?

[abezon]

The $1 bit stems from the old days when people didn't want others to know the price at which their land was bought/sold. Since deeds transferring title to land must be recorded, and the recorder's files are public information, lawyers started using the phrase "A conveys to B for $1.00 and other good and sufficient consideration" on the deed.

We still use the $1 bit because real estate lawyers are a conservative lot and figure, if it's worked for centuries, why muck about with it? Never mind that fact that real estate sales are now published in the paper by the excise tax office**************

Got it. Thanks. Totally agree with your initial reply.