Capital gains when splitting property for sale

[adringley]

Hello. Thanks in advance for any help. We sold our primary residence in November 2021.  We then purchased another home in October 2022. The property is a combination of multiple lots with a house and a separate garage. We are turning the garage into a house. We will retain that house and the lot it sits on and plan to sell the original home and the remaining lots. We think we could make more money by selling the house and 2-3 lots together and then sell the 2-3 remaining lots separately (depending on how we decide to list it). I am trying to figure out what would be our best option for taxes and capital gains. Since this will be the second residence we have sold in under 2 years and we have lived in this property for less than one year, I assume we will be paying capital gains on any profits. I don't even know I should be calling it a primary residence or an investment property since the intent from the start was to live in it, renovate the garage and then sell part and retain part of it. We would likely have a significantly larger profit from dividing the properties and selling a few of the lots separately from the house, but if doing so means we end up paying most of the difference in taxes, then I don't see the point. We purchased the entire property for $400,000. I think we will have about $70k in renovations, with about $60k of that being on the house we are keeping and $10k on the house we are selling. I'm thinking if we sell the house and 2 lots, I would probably list that portion for $250k then list one lot for 25k and two lots combined for $50k. If I list the house and three lots, it would probably be $260k and then two lots combined for $50k. If I list the house and all the lots together it would be for $275k. So depending on how we do it, we could have roughly a $30-50k difference in potential profits. I'm hoping to retain a mortgage on the house we are keeping for @$200k with an 80%LTV, assuming it's going to be worth about $250k appraised value. I have so many questions. First of all, can I use the entire $70k I spent on renovations to adjust my cost basis even though I'll be retaining part of the property? Secondly, how is the value of the property I'm retaining determined for tax purposes (appraised value, loan value?) Thirdly, if I end up with 2+ different sales when splitting the property, do I just do the math and count them all as one sale on my taxes? Any info or advice on what to do would be much appreciated. Thank you!

[JosephS1]

As you said, there are many possibilities to consider here.  Firstly, I will have to assume the profit on the sale of your former primary residence qualified for the exclusion on the sale of a personal residence.

What you are proposing is a type of land development.  Before we get into the numbers there are a couple of items that you may want to consider before doing what you propose:

Does the municipality in which your new purchase resides require a land development plan before you can sell off/build on other segments?  You should check with the municipality when you apply for permits, if necessary.  Also, there are certain regulations here and there that if you were to sell multiple parcels you could be considered a real estate dealer or professional and that could make the profit subject to ordinary income and possibly self employment tax.  You should consult with a real estate professional about that possibility.

Now for your potential sales.

It would be advisable to obtain an appraisal on the current value of the house, garage, and individual lots if you do not already have one for allocation purposes.  You purchased the entire property for $400,000 so some conclusions can be made regardless of whether you have an appraisal or not.  From your scenario, it appears you have a house on one lot, a garage on another lot, and 5 additional lots.  

Total envisioned costs as you have laid out:  $400,000 initial purchase plus $70,000 in renovations with $10,000 to the existing house and $60,000 to the garage to complete the new residence.

Possible allocation based on your believed sales values and possible appraised values from above per total expected to be expended:

Value of house plus 2 lots - $240,000 (Future value of $250,000 less $10,000 in renovations)

Value of 2 lots - $50,000

Value of future residence before renovation - $190,000 (Future value of $250,000 less $60,000 in renovations)

Total allocation base:  $480,000 ($240,000 + $50,000 + $190,000)

Total Potential current value based on the purchase price of $400,000:

House plus 2 lots - $200,000 ($240,000/$480,000*$400,000), net gain $40,000 ($50,000 less renovations of $10,000)

Value of 2 lots - $41,667 ($50,000/$480,000*$400,000), a gain of $8,333

The cost basis of future residence - $218,333 ($190,000/$480,000*$400,000) + $60,000

You should be able to use the above valuation formula for any of the proposed sales you are envisioning.

Each sale you make must be able to stand on its own merits as to the allocation of the original cost and any additional improvements made specifically to the property sold.

The amount of capital gain tax you pay will be based on whether it is long-term or short-term obviously.  Any short-term gain is taxed at your ordinary income rate and any long-term gain will be taxed based on your taxable income but can be anywhere from 0-20%.  There is also a 3.8% Net Investment Income Tax on investment income that exceeds certain modified adjusted gross income limits.

Capital Gains Rates

Net Investment Income Tax

@adringley