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George Saenz, the Bankrate.com Tax Talk columnistSelling strategy for investment property

Dear Tax Talk,
My neighbor recently died and we have put in a bid to buy her house. My husband is a contractor and my two sisters are going to go in on the house with us. My husband and I have had a rental house for five years as well. We plan to update the neighbor's house and add a master bath and bedroom in the upstairs attic.

We are using a HELOC for our financing split three ways between my two sisters and us. I am wondering if we are better off spending a year to rehab the house and sell it next summer (we would then be paying 8 percent interest on the $300,000 loans for a year), or would we be better off to fix it up quicker and sell it as soon as we can? I thought I read that if you hold a property for a year, your capital gains tax is less. Can you tell me what the difference in tax is?

We will do high quality work either way, but financially, please give us any advice you might have on the best method. We want to do it right the first time. Thanks for your time.
-- Sara

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Dear Sara,
You can usually cash out $100,000 from your home, use the proceeds for any purpose and deduct the interest on the home equity line of credit as an itemized deduction. This means you and your sisters, if already itemizing deductions, will get an additional tax benefit from the borrowing.

There is a significant tax difference when you sell the property after a year as opposed to selling it within one year of purchase. The maximum long-term capital gains rate of 15 percent applies to gains realized from the sale of property held for more than one year (i.e. one year and one day). Property held for less than one year results in a short-term capital gain, which is taxed at the same rate that applies to all your income.

For example, as a married couple, if your taxable income is more than $61,300 before the gain, you can expect to pay 25 percent tax on short-term gains instead of the 15 percent long-term capital gains rate. If your income is higher than $123,700, you'll pay a higher rate, as shown in Bankrate's tax rate table. The interest on the entire loan amount is $2,000 per month ($300,000 at 8 percent). You have to compare your cost to the additional tax you would pay by not holding the property for a year. Chances are that the tax will be higher than the monthly mortgage interest.

Usually, when you construct property, you have to divide your gain between long and short term, depending on the amount completed within a year of sale. However, in your case, since you're only remodeling existing property, this allocation should not be necessary so that if you sell more than one year after construction, all your gain on the property would qualify as long-term gain.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy -- Posted: June 1, 2006
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