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Capital gains vs. interest


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By David in Macomb, MI on 1/19/2005


Hi everybody. I bought and read The O-B Book and found it very useful for a first-time owner-builder. I have also purchased and read a few other books on the same topic. I am finding that they all have one thing in common. All of the books lean towards the idea of "building up" by living in the house for (at least) two years in order to avoid capital gains tax. But none of them compare the cost of capital gains paid to the 24 months of interest paid to the bank!

Let's do an example:

Say I owner-build a house that will appraise (including land) for $250,000 when completed. Now say that it cost me $200,000 (also including land) to build. That leaves $50,000 of move-in equity. So far, so good.

Now, say I simply turn around and sell the property immediately. I would be responsible for capital gains tax on $50,000 (assuming I sold the property myself, even less if I had Realtor commission to pay). Let's say that capital gains tax is 20% (I think it's actually 15% now). That would be $10,000 in tax. OUCH! But wait...

Let's now assume that I want to avoid that big hit on my profit by living in the home for two years. Maybe I'm missing something, but when I amortize a $200,000 mortgage on a 30-year term at 7% interest (yes, I know there are lower rates, but not that I'm going to be approved for). After my two years are up and I'm ready to sell, I will have paid $28,867 on an interest-only mortgage. DOUBLE OUCH!

OK, okay, let's be fair to those of you with flawless, perfect credit. We'll say 5% for the same example. That's still $20,523 interest only. STILL DOUBLE OUCH!

Now, I may be wrong, but the way I see it is if you were working to "build up" to own your home free and clear after, say, 3-4 owner-builds, doing it by avoiding capital gains would be 6-8 years. If you turned each house over and started another, couldn't you do the same in 21-28 months (assuming a 7-month build time like books say)?

Hey, I could be way out in left field here, so any comments would be most helpful.


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By Jon in Olathe, KS on 1/19/2005


Yes, but after two years, it would appreciate to more than $50,000 and could be sold for more $$.

You would still have to pay interest on the mortgage for the home that you live in - be it the O-B house or some other.


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By David in Macomb, MI on 1/19/2005


Jon,

You could be right, but the appreciation would have to be pretty big to make up for it. I'm just not convinced that the appreciation of your house is going to keep up with the interest that you're paying each and every month. That is, of course, until the break-even point in your mortgage where principle payment meets interest payment. But that's a lot longer than two years. I didn't mention it in the first post, but I guess I am assuming that you are already living somewhere. I don't think that too many people that are out on the street decide to become owner-builders just so they have a place to live. Again, I could be wrong, though.


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By Kenneth in Lees Summit, MO on 1/19/2005


I am going to take a shot here, as this could be an interesting discussion.

In your example, you can take your capital gains of $50K immediately by paying $10K in taxes, walking out with a $40K profit by O-B and never actually living in the house. This is true, but where are you living? If you are building in the market you currently live, you are paying interest now. If you are renting, you still pay interest albeit indirectly.

Back to your example though. You are paying about $14K/year interest at 7%. If you itemize, this interest is tax deductible. If you are living in a $250K house, you are probably in the higher tax bracket, so $14K interest equates to a tax deduction of about $4K federal (and another deduction for state, although all state tax laws vary) so your net interest payment is about $10K or less (agreed that you get to take a base deduction if you don't itemize, but if you itemize you get other deductions as well and lets keep this as simple as possible).

So considering tax implications you are paying $20K interest over two years to avoid paying $10K in capital gains tax immediately. You are correct in that this isn't the best investment out there, but this still begs the question of where are you going to be living as this has some cost.

Now then lets factor in some appreciation. Let's say that the $250K house appreciates at 3%/year (very low if you are building in a hot market?). After two years you are looking at $265K and the potential for $65K capital gains tax-free. Back out your interest that you paid over the past two years, and you are looking at about $45K free and clear. Now consider that you have to live somewhere, and this has an associated cost to it. Suddenly the capital gains tax avoidance strategy doesn't look quite so bad. If you can build in a hotter area and achieve 5% appreciation, you are looking at over $75K tax-free capital gains - now the capital gains avoidance strategy starts to look very good.

Please note that is neither free money nor a get rich scheme. O-B is a lot of work - the book says 2,000 hours invested in your house. I am building a custom house (no production-based items here), doing a bunch of work DIY vs. subcontract, and can tell you I will have well in excess of 2,000 hours. You cannot discount the amount of work. You also need to back the capital gains back in to the hours you work to figure if this is how you want to spend your time (you have to spend it doing something, I am looking forward to sleep ;-).

However if I were doing this for profit, I would do things completely differently. I would stay out of the custom market, base my plan on a production model that I could build in different trim levels so I could use one plan multiple times, using the same plan multiple times allows you to fine-tune your suppliers much better (saving considerable time here), shop my suppliers only once instead of every house, shop my subs only once instead of every house, doing more business equates to more discounts for supplies. Suddenly I sound like a production builder!


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By David in Macomb, MI on 1/19/2005


Excellent. That was exactly what I was looking for. I want all to know that I didn't pose this topic because I was convinced that it was a bad idea. The numbers just were not adding up.

Now, I would like to omit the mortgage that I am paying where I am living while the O-B house is being built and finished. I want to say that is where (for now) I am happy. I was building the O-B house purely for profit. I wanted to make sure that when I do move, I will own my house and land.

I know that I will be paying interest for the house I am living in. I'm just saying that I built a house, but now I don't really want to live in it. I also don't want two mortgages, so I decide to sell the house I just built. Yea, sounds weird, but not really.


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By Jon in Olathe, KS on 1/19/2005


It sounds more like the "capital gains" should be called "net profit" and would be taxed as if you are self-employed as a general contractor.
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By David in Macomb, MI on 1/19/2005


Well, in essence, that's what it is. Only with capital gains, it doesn't matter if you are filing self employed or personal, the tax is going to be the same.

Back to my issue, though. Don't you think that if you went ahead and took the capital gains hit and immediately built another house, you would reach your goal much faster, or at the very least, be able to clear a lot more profit in 6-8 years like the original "building up" plan? Even if you continued to build the same house like in the post above?


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By Kenneth in Lees Summit, MO on 1/19/2005


There is a fine line between "professional" builders and O-Bs. I find that the codes people tend to treat me much nicer, are much more patient, much more willing to provide technical assistance over the phone, etc., all because I am an O-B and have never done this before. If I cross over this line, suddenly I am a professional builder and all kinds of things change.

For example, as a professional builder I have to submit my subcontractor list when I pull the building permit (so they can verify all my subs are licensed to work in my locale, a revenue enhancer), I have to submit all truss plans and associated engineering, and a whole litany of other requirements including timeframes to get the house constructed (six months from digger to C/O). As an O-B, I don't need to submit my subcontractor list, I can sort my truss supplier later and have to have the plans, templates, and engineering at the house, etc.

One of the opportunities for O-Bs is to continue to shop subs until the work actually starts (i.e. I find subcontractors much more willing to provide bids once the house has started, and much more competitively, as a professional I don't have this option as my subs are locked per my permit). What you are describing is not O-B but professional GC, and at least in my locale this has additional administrative burden, much of it with an associated cost. On paper, GCs seem to make a lot of money, but there is a lot of inefficiency in the process we can address only by being O-B.


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By Don in Agoura, CA on 1/19/2005


Just wanted to add one small point. The calculations will be sensitive to the percentage profit on the house. Meaning the example being used of $200,000 cost and $250,000 selling price might show paying interest for two years as a bad idea.  i.e. paying $20,000 to save $10,000. But, along the same lines of the appreciation argument, let's say you did a really good job value engineering the home, and built a $300,000 home for $200,000. Now the tax savings would be $20,000 which would change the tax to interest comparison, significantly, especially when taking into account any additional appreciation.

This is of course in addition to all the other excellent reasoning by other posters.

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By Peter in Gilford, NH on 1/20/2005


Capital gains come in two flavors: short-term and long-term. Short-term gains are taxed as ordinary income, the taxes on long-term gains (for assets held more than one year) can range from 5% to 28%.

The 25% rate is for property owners and real estate investment trust (REIT) investors in the 25% income-tax bracket or higher who hold property for more than one year.

So to do the calculation correctly, you need to first know how much money you will make outside of building your house (to figure your income tax bracket), how long it takes to build your house and when you invested in the house. After all, the one dollar you invested at the beginning of the building process might be long-term capital gains, but the last one dollar invested might not be.

Think of your investment in the house like dollar cost averaging in the stock market. Need to account for each investment separately.

The 15% long-term capital gains rate is for securities (stocks).

And now to make things more interesting, if you are not going to live in the house and build it as an investment; you can deduct and amortize the costs against your ordinary income in the year you spend the money.

So, let's say you make $120K and pay $20K in taxes. But you put out $100K for building the house. This $100K would be a loss (via Schedule C on your 1040) and wipe out $100K of your $120K income, saving you the $20K in taxes (ignoring AMT calculations).

But when you sell the house, your basis in the house will be $100K lower and the profit will be $100K higher. But you might have switched ordinary income into long-term capital gains (usually a good thing). To get the 15% long-term capital gains, you start a company and invest in the stock of your company (which takes your money and builds a house) and then purchases your stock back at the sale of the house. To keep the Schedule C deduction going, the company would have to be an "S" corporation.

And to make a little more pain, your corporation can use cash accounting or accrual accounting. The accrual accounting lets you be your own Enron/Worldcom. Expense items when you get the bill, not when you pay them. The big guys use this to move expenses from one tax year into another (avoiding taxes or pushing the tax bill into the future).

And a little-known loophole, if you're a Lichtenstein corporation doing business in the U.S. your corporate tax rate is 4%-5% under a tax treaty with the USA. So your Lichtenstein building company builds houses and pays only 4% on its profits. Some of the largest public companies in the US are Lichtenstein corporations.

If your house can be considered a tree farm, a regular farm, part of a failed oil exploration, developed in an economic development zone, ... and many other loopholes, special taxation rates are available to you.

Has your head popped yet? Don't you think it's time for tax simplification as proposed by President Bush? The awful truth; you have to be a genius at taxation, accounting, international law and building to get your answer.

In addition, if you have enough money to buy the brightest minds on the subject, you don't have to pay tax; but the IRS is going to audit you for expensing that $20 subscription you deducted last year for your "This Old House Magazine".

(Name withheld at request of the poster because he believes the IRS has access to CIA predator system).


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By David in Macomb, MI on 1/20/2005


I have no idea how to respond because I really have no idea what I just read. I'm going to pretend that I went to sleep for the last ten minutes.

I guess I'm just going to stay there. It will probably take me the better part of the next two years taking classes to decipher what I just read anyway.


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By Peter in Gilford, NH on 1/20/2005


David,

If you stay in the house, the classes can be added on to your basis in the house, so when you sell, you can in essence deduct the cost of the classes.

If you don't stay in the house, the classes can be deducted through your building corporation as an employee benefit. This assumes that the education benefit is available to all employees in your building co; otherwise you will have to take the value of the classes as ordinary income.

LOL

Peter


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By Peter in Gilford, NH on 1/20/2005


David,

I'm offering two solutions to your problem: If you take the blue pill, you will return back to your normal life and will forget you ever started this thread.

If you take the red pill, your "normal" life will be gone forever and I will reveal to you inner secrets of the taxation matrix. People all around you live day in and day out, not knowing they live within the taxation matrix. But if you take red pill, you will know; but David, once you take the red pill, there's no way to go back!

It's your choice.

Peter


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By David in Fredericksburg, VA on 3/18/2005


Generally, if you are doing an O-B, you have to live in the house for some period of time after it is built (1-2 years depending on area/codes). People who build a house to sell it immediately are "builders" -- not "owner-builders". And builders are required to have licensed subs do all the work.

Even if you only have to live in it one year, you might as well live in it for two years so you can then get the $250K single / $500K married capital gains exemption after the sale of the house.

If you are building a house with the intent of selling it in two years, then instead of getting a conventional 30-year mortgage, go with an 3-year or 5-year ARM, which will give you a lower interest rate. You could even go with an interest-only ARM which would result in an even lower interest rate and monthly payment while you live in the house.

Given that interest rates have probably bottomed out and will be going back up over time, ARMs probably aren't as good an idea for someone intending to stay in a house long-term but for an O-B looking to flip the property in two years, its a good deal.

Dave


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By Gen in Mt Pleasant, SC on 3/18/2005


Interesting topic...

I have recently been told that after you live in the house for two years, you can rent the house out after you move out for up to three more years and then sell and still not have to pay capital gains.

Someone else told me that you had 18 months to sell the house without paying CG.

?????

I knew that you had to live in it for two out of five years, but does anyone know if this is true?


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By Joe in Falling Waters, WV on 3/24/2005


Yes, that is correct, you only need to live in the house for two out of five years to take the capital gains exemption. You could theoretically build a couple of rental properties and a house for yourself in a five-year period and sell your two rentals after collecting the rent for three years each and pay off your O-B residence. If you don't mind being a landlord, this seems to be one of the fastest ways to own a home free and clear. Not to mention you would gain the O-B experience on smaller houses that you may not want to live in forever, but that make good rentals.
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By Drue in Henderson, NV on 3/24/2005


Yes, what you say is true, but my wife and myself decided to do a working tour of the USA for about 18 months. This apparently does not conform to the tax law of "inhabiting" the home, so we now have to wait 12 months more than people who live and sleep in their home to break ground.
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