Sweat equity is the value in property or stocks that you acquire through unpaid work. This can be physical labor you did on a real estate property that you own, or professional services that you performed for a business in exchange for stock in the company. The tax consequences differ according to how you acquire the equity, and how you cash it in.
Real Estate Sweat Equity
You can earn sweat equity if you purchase a property that is in poor or mediocre condition, and you improve the state of the premises, which increases its market value. Although the term sweat implies you did the work yourself, you can also hire contractors to do part or all of the repairs and improvements. Most commonly, people acquire sweat equity on their primary residence, but you also can earn sweat equity on a rental property. Keep records of the money that you spend on supplies and professional services. You’ll need those figures at tax time.
The increased value of your property resulting from your improvement efforts can trigger an increase in your property tax because the tax is based on the market value of your home. Cosmetic changes, such as a fresh coat of paint, new carpeting or refinishing floors might not have a significant impact. But if you put on an addition, finish a basement, enclose a porch to create a sunroom, or build a garage, you could increase the base value of your home that the county uses to calculate your tax bill.
When you sell a residential property where you have lived for at least two of the past five years, as of 2017 you can exclude $250,000 in profits from capital gains taxes if you’re single and $500,000 if you’re married. This is where you need those home improvement figures. The profit is the sales price, minus the price you paid when you bought the home, minus any improvements you made.
For example, if you bought a house for $250,000 and you paid $7,000 for materials that you used to fix it up, and $3,000 for services from electricians and plumbers, the tax basis of your home is $260,000. If, for example, you are able to sell it for $300,000, your profit is only $40,000, which is well below the federal exclusion.
Qualify and Use the Federal Exemption Multiple Times
There is no limit to the number of times you can take the exemption for your main home, as long as you meet the residency requirements. However, you're ineligible for the exclusion if you excluded gains from another home's sale during the two years before selling the home in question. The exemption, however, does not apply to any non-residential investment property you own.
Business Sweat Equity
Sweat equity refers to the value of work that a founder or an early-stage employee puts into a company and is paid for in shares in the company. Often professionals use their typical hourly rate and multiply it by the uncompensated hours they worked to come up with this figure. Alternatively, you can use the value of the work on a project basis.
If your typical hourly rate is $125, for example, and you spend 200 hours designing the layout and purchasing the machinery for a new factory, you could claim $25,000 in sweat equity. You could argue that outsourcing this project would have cost your partners $40,000, so your contribution could be worth the higher amount. In either case, the amount you and your partners agree on would be translated into shares of stock in the company.
Business Sweat Equity Taxes
Tax considerations come into play for business sweat equity when you sell the shares you earned in lieu of wages. The IRS treats this as ordinary income, so you would pay tax on the sold shares at your income rate.
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