Sweat Equity & Taxes

Sweat equity in real estate is a pretty common term. But even if you have heard of it, would you know how to calculate sweat equity in a house? Is it possible to use a sweat equity calculator to determine the value of the work you have put into a property? Also, what are the sweat equity tax implications for you if you choose to claim it?

Originally, products and services were regularly traded. Instead of handing someone cash for a purchase, people would exchange what they could offer as a form of payment. Although most businesses today require payment in the form of money, there are instances where a person pays for goods or services through labor, also known as sweat equity.

This is especially seen in the real estate industry, where a tenant may perform services in exchange for a reduction in rent costs. For every type of business, though, payment in the form of services is just as taxable as monetary payment is.

Most often, sweat equity comes up in a real estate context, although that isn’t the only industry affected by it. Investors regularly choose properties that need work, with the plan of doing the labor necessary to make a profit on that investment. That labor is deductible on taxes, provided the investor pays someone else to do it. If the owner does the work, it is not.

At the same time, though, sweat equity can result in higher taxes, especially if it increases the value enough for a property owner to see higher property taxes. Local authorities will periodically perform an assessment on a property, and if they’re aware of improvements you’ve made, it will increase the value of your house. Since the taxes you pay are based on that value, that means more money out of your pocket. This especially affects property owners who plan to continue to own the house after making those improvements.

​Read More:​ What Are Property Taxes?

Some business owners attempt to deduct their own hard work when they’re paying their taxes. If a startup founder is operating as a one-person operation, for instance, she may choose to count the hourly fee she would have paid a graphic designer to build her website or create a logo for herself. At the end of the year, when she’s claiming the income she earned, she would then deduct that sweat equity as an hourly fee, just as she would have done if she’d expensed hiring a freelance designer.

This move can cause problems, though. First, you may find that it leads to an audit, where you have to justify the expense. Even if you’ve documented everything, however, courts in the past have ruled that the expense must actually be incurred before a business owner can deduct it.

​Read more​: Tax Audits: What Are They, Why Are You Audited and IRS Audit Outcomes

In other words, you can’t simply choose a random rate for the service you’re providing to your own business and assign it. You must have been charged that fee, usually by someone who is not you.

In the early days of forming a business, entrepreneurs will often make an offer of shares in exchange for the work people provide. A friend who provides consulting services, for instance, may sign a sweat equity agreement with you that puts in writing that he has a stake in your business. The services they provide count toward your business’s valuation, even though no money changed hands.

When you sign that agreement, you’ll need to assign a value to the services being provided. If the investor doesn’t have a set fee for the services he offers, determine the fair market value for that service and include a set number of hours in the agreement. The agreement will also need to outline how much equity you’re granting in exchange for these services, all of which will help you set a valuation for your business.

When a business accepts services in exchange for equity, the IRS considers the exchange two separate transactions.

The first transaction is the provision of the services, which is taxable as though you’d paid the person in cash. At tax time, you’ll need to claim the services you received and pay taxes on the value of that labor. If your investor provided $2,000 worth of free labor in exchange for equity in your company, for instance, you’ll claim $2,000 in payments and pay taxes on that amount.

The person doing the labor will also have a taxable event. In that case, though, she’ll need to pay taxes on the income she earned in exchange for the services provided. If you’d paid her $2,000 in cash, she would have had to report that on her taxes and pay a portion of it to the IRS at tax time. The $2,000 in equity outlined in your agreement counts the same as cash and will need to be claimed and taxed.

Interestingly, though, the timing of your exchange can make a big difference. During the initial stages of putting your business together, you can distribute equity as you see fit without a taxable event. If you’re setting up a business partnership with three other professionals, for instance, you can each agree to take a certain percentage stake in the business, put it in writing and not claim that as taxable income.

The reason equity distributions aren’t taxable as you’re incorporating is that there is no business yet. Once you’ve formed, your business then can be assessed a dollar value, made up of all of the assets you have in it even if you haven’t brought in a dime.

By the same token, investors can also get equity in your business without putting in any work above and beyond what you require of them since they’re getting equity in a business with no worth.

What is sweat equity in real estate? In addition to investors, often homeowners will put money into their property in the hopes of earning a return. This work is not tax deductible, but generally, it’s done with the hopes of making a bigger profit on your property when you do sell.

Even if you plan to stay in a place the rest of your life, knowing you’ve done work that increases the value of the home you’re in can help you sleep better. But all sweat equity is not equal when putting work into your house. By doing any renovations yourself, you can save money, maximizing your investment, but you may find that even then, you can’t recoup the cost of some enhancements.

Experts keep running lists of the remodels that can bring the most value, but typically they relate to minor upgrades to kitchens and bathrooms. Small exterior improvements can also make a difference, upping your home’s curb appeal, including landscaping work.

​Read More:​ Home Improvement & Tax Deductions: What's Deductible & What's Not

You’ll put plenty of sweat into maintaining your property if you choose to rent it out. Whether it’s a vacation rental or you have long-term monthly tenants, you’ll likely find yourself dealing with basic repairs, including things like leaking roofs, malfunctioning appliances and termite infestations.

If you outsource this to a repair person, you can claim the cost on your taxes as a deduction to offset your tax liability. However, if you put the work in yourself, you can’t set an hourly rate and claim that on your taxes. But you can deduct the cost of materials.

When deducting the cost of repairs to your rental, it’s important to distinguish between repairs and upgrades. You can’t, for instance, claim the cost of updating your kitchen in the hopes of attracting higher-dollar renters. This extra expense will be covered when you claim your property depreciation that year.

The IRS defines improvements as updates made to better the property or adapt it to a different use, but restorations also count as improvements for tax purposes.

When a property owner receives labor from tenants, though, that work is taxable. If your tenant negotiates with you to paint and repair his own apartment, for instance, with the amount you would have paid someone else deducted from his rent, you’ll be responsible for claiming that amount as income.

You would simply include the amount of rent that person would have paid when you claim your income that month. The same rule applies if you have an arrangement with a tenant where you reduce rent in exchange for them paying for certain expenses.

If the tenant replaces a broken lock on the door, for instance, and you deduct the expense from that tenant’s rent, you’ll still need to claim the full rent amount for that month as income. If your arrangement with your tenant is that they pay certain utilities and you deduct that from their rent, the amount they paid for utilities is considered taxable income.

However, if the lease states that the tenant is responsible for paying utilities and other expenses, all you’re responsible for tracking and claiming is what that renter paid you for rent each month.

There are a variety of reasons to make sure you have sweat equity valuation report to prove any sweat equity agreement before the work begins. One is for tax purposes, since you may be audited and need to back up your claims that work was performed. The more paperwork you have on hand, the better off you’ll be. This will also be helpful to refer back to if you ever strike an agreement with someone else.

​Read more​: 6 Components of a Contract

Another reason for a legal contract is that it protects you as a business owner. If you have an agreement that a new business partner will provide consulting services in exchange for equity in the company, this needs to be clearly outlined in writing. Otherwise, either you or the person providing the service could fall through on those promises with no recourse. You can find advice online for drafting such a document, but having it reviewed by an attorney will offer you extra protection.

The same concept found in new businesses can also be seen in real estate investments. An investor may not have the funds on hand to purchase a property, but she may have the contacts and background that brings value to purchasing and flipping properties for profit. That investor could strike a sweat equity arrangement with a business partner who does have the cash, offering to do the hard work in exchange for the other person paying the majority of the purchase cost for the property.

In order to take this approach, though, investors need to have a good understanding of the best type of property investment. You’ll also need to know the value of your labor and how that equates to the equity in the property you’re getting. In other words, if you and the other investors have agreed to split the proceeds on selling the property after you’ve updated it, you’ll need to make sure your half will make all the hard work worth it.

It’s also important to consider any capital gains tax that will be applied to the property, particularly if you plan to sell it within ​one year​ of purchasing it, since short-term gains are applied at a higher rate.