Sweat Equity & Taxes

by Mary Bauer, studioD

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 by sprucing up an old house.

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.

Property Taxes

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, 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.

Federal Taxes

Profits from your primary home are eligible for captial gains exclusion.

When you sell a residential property where you have lived for at least two of the past five years, 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.There is no limit to the number of times you can take this exemption, as long as you meet the residency requirements. The exemption, however, does not apply to any non-residential investment property you own.

Business Sweat Equity

You can acquire stock in lieu of payment for professional services.

Sweat equity also refers to the value of unsalaried work that a founder or an early-stage employee puts into a 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. For example, if your typical hourly rate is $125, and you spend 200 hours designing the layout and purchasing the machinery for a new factory, you can claim $25,000 in sweat equity, or argue that outsourcing this project would have cost your partners $40,000, so your contribution is worth the higher amount. In either case, the amount you and your partners agree on should be translated into shares of stock in the company.

Business Sweat Equity Taxes

You must pay taxes when you sell sweat equity shares.

Tax considerations come into play for business sweat equity when you sell the shares you earned in lieu of wages. As of 2011, the proceeds from the sale of such stock is taxed at the 15 percent long-term capital gain rate. Politicians have talked about the possibility of an enterprise value tax that would treat such earnings as regular income. If such legislation passes, you might have to pay up 35 percent in taxes, depending on your yearly earnings.

About the Author

A retired federal senior executive currently working as a management consultant and communications expert, Mary Bauer has written and edited for senior U.S. government audiences, including the White House, since 1984. She holds a Master of Arts in French from George Mason University and a Bachelor of Arts in English, French and international relations from Aquinas College.

Photo Credits

  • Creatas/Creatas/Getty Images