One of the most popular real estate investment scenarios goes something like this: elderly Mrs. Johnson at the end of your street decides to move to Florida, leaving the house to be sold "as is" by her busy son. It has been neglected for decades, and looks fairly unattractive from the street.

After multiple Realtors give it their best shot, the son tries to sell the house by himself, and lowers the price to an amazing $75,000 as is.

You know that everything in this neighborhood is worth $150,000 when fixed up, but you can buy this house for half price. You've looked at the house, and you know you can fix it up for about $15,000. After marketing expenses of about $9,000, you can sell the house for almost $150,000. It looks like you are going to make right around $50,000!

Here comes the question: how much income tax will you owe on that profit?

While it seems like a simple question, there are a number of steps involved in arriving at an answer, and the IRS is all to happy too help you through the process.

First, the IRS wants to determine your original intent when you bought the house. Did you originally plan for this house to be one that you would fix up and sell quickly, or was your original thought to buy this house and hold it for a long time as an investment? The answer is very important.

If you were primarily looking at a quick profit, then the IRS considers the house to be inventory, just as if you had a pair of shoes on the shelf in a shoe store. Any expenses you incurred in the acquisition and fix-up are deducted against your net selling price, and the remainder is considered profit.

That profit is treated as "earned income," and everybody wants a piece of your pie. Depending on your other income, you will likely pay 28% federal tax, 6% state of Georgia tax, plus 15.3% social security and medicare tax, often called "self-employment" tax. That's a whopping 49.3% in tax, and it's almost enough to discourage you from buying the house in the first place.

In our example, if you made $50,000 profit on the deal, your tax bill would come out to approximately $24,650. That's sort of like having a 50-50 partner on everything you do.

Fortunately, there are other ways to handle this transaction. Let's look at a few alternatives:

* Let's say that instead of a quick profit, your original plan was to hold the house for some period of time as a long-term investment. Having that plan removes the house from the inventory category in the eyes of the IRS, and helps lower the tax burden. That's because investment income is not subject to self-employment tax.

If you fixed up the house, then held it as a rental house for several years, the IRS would likely agree that your house has been an investment. The longer you rent it, the stronger your case. And then, if you decide to sell it, the profit is no longer considered regular income. Instead, it is now
considered a long term capital gain, often described by the acronym LTCG.

Calculating long term capital gains is a little more complex, involving the recapture of depreciation, but let's focus purely on the income tax rates. The current maximum rate of federal taxes for long term capital gains is 15%, plus 6% for the state of Georgia. Because your original plan was to make this house an investment, social security taxes do not apply, and your overall rate of tax has dropped from 49% down to a more manageable 21%.

In our example, taking this course of action would cause your overall tax bill to be reduced from $24,650 to $10,500. Now you begin to understand why so many investors decide to rent their houses, instead of quickly reselling them on the retail market.

* What if your original plan was, indeed, to make this property an investment, and you fixed the house up with that as your original intent. You never advertised it for sale, and you placed a tenant in the house as soon as you could find one.

Then six months into the lease, the tenant called you and made an unsolicited offer to buy the house for top dollar with no fees and no repairs. Even though it was never your plan to sell, it now makes good business sense to do so. In this case, the IRS would likely agree, allowing you to pay tax on an investment rather than inventory. But the total period of your ownership is less than one year. That makes a big difference.

Profits on investments of less than one year are called short term capital gains, and they are currently taxed at regular income tax rates. In your case, that is probably 28% for federal tax plus 6% for the state of Georgia, for a total of 34% total tax. Again, social security taxes do not apply to capital gains. Your tax bill would jump to $17,000 in this case.

* Perhaps the best scenario would be for you to buy the house, move in and make it your principal residence, then live there for a couple of years while you are in the process of fixing it up.
Provided you have owned and occupied it for any two of the five years immediately preceding the day you sell it, the IRS says you, as a single owner, can exclude up to $250,000 from your calculation of capital gains.

In our example, let's assume that the rate of appreciation in your neighborhood stayed low for those two years, and you were only able to sell it for the same $150,000 that it would have brought two years earlier.

Your gain would still be exactly $50,000, but because you used the house as your personal residence, you would have no tax due whatsoever. The entire profit is yours to spend or save as you see fit, with no requirements to re-invest or buy another house.

The important point here is that the IRS treats profits in different ways depending on how you plan your investment. My advice is to consult with your tax professional before you set your plans.