Tonight let’s answer a question that has provided some scary moments for me by proxy. The latest example happened a few years ago, when I was contacted by a reader of this blog, the brother of a real estate investor. He was a part time real estate agent in a small west coast town. His sister had been investing on her own, since her husband had passed away, many years earlier.

He called wondering if his sister’s (‘Darlene’) math was correct. She was in the middle of a sale of one of her properties, a duplex. While visiting their parents the two had been talking, when she volunteered how she wouldn’t be on the hook for capital gains taxes cuz her net would be almost less than her closing costs when she’d originally bought it.

Red flag — goose bumps.

The answer to tonight’s question, is taken from the November 17th post which contained many such questions. This one came from the conversation I had with the above mentioned reader.

You bought a duplex 11 years ago for about $100,000 and sold it last week for $200,000. However, since you re-fied at the top of the market for $180,000, your agent informs you your net check from escrow at closing will be just $3,800 or so. You figure you’ll pay the taxes on that small amount and be done with it. Just a loose ballpark figure — what might your tax bill be?

I got the the call from Darlene’s brother roughly a couple weeks before her sale was scheduled to close. She and I spoke the following day. Here’s what I told her.

Let’s break this down to its basics.

1. She paid $100,000 for the property in 1996, an investment from the start.

2. She took over $2,700 a year in depreciation.

3. In 2003 she refinanced it for $180,000, as she desired some cash.

4. The market correction had reduced the value down to $200,000 from a high of nearly $300,000.

I explained to her, as gently as possible, that her capital gains tax plus the depreciation ‘recapture’ tax (higher tax rate than the gain) would be somewhere around $17-20,000 give or take. Since I didn’t have her tax returns that was as close as I could hope to come.

She was speechless. (Paraphrased from memory) “How on God’s green earth can I possibly owe taxes when I’m barely coming out with enough money to go on a decent vacation?”

The answer’s pretty straight forward.

She bought low, sold high, took over a decade of depreciation, and therefore was about to incur a significant tax obligation. Her mistake? She thought since the loan balance on her recent refinance took so much of her equity away, coupled with the market correction, and that the net check from escrow was gonna be so small, no taxes would be owed.

The IRC (Internal Revenue Code) for the most part, doesn’t take loans into consideration when calculating either adjusted basis or capital gains. Any new loans are your business, not theirs. Therefore, here’s the incredibly oversimplified math.

Paid $100,000 — minus roughly $30,000 in total depreciation taken — plus costs of sales $24,900 (many repairs + termites) = adjusted basis of approximately $95,000. Then the IRS really makes it simple. All they do at that point is to separate the ‘depreciation recapture’ from the gain. We’ll do that in depth some other time, but you can see where this is going, right?

$200,000 minus $95,000 equals a lotta gain. Even though she netted less than $4,000 she would’ve had to cough up the taxes owed the following April. What to do?

She had two choices. Go through with the sale and pay the taxes — OR — stop the sale and keep the property. She chose the latter, which was made possible by a very generous, gracious buyer. It happened it was her longtime neighbor, who’d wanted the duplex for his grandkids. Darlene gratefully agreed to rent one side to them for a slight discount, which satisfied her friend/neighbor.

it coulda been ugly though.

BawldGuy Takeaway: In virtually all scenarios any loans and/or their respective balances won’t make a hill-a-beans difference when computing potential capital gains or losses on real estate investment properties. If it makes ya feel any better, it’s a very common, though mistaken assumption that the net one gets from a sale escrow means anything whatsoever in gain/loss computations.

Epilog

That Christmas I got a very nice card, along with a gift, allowing me to use her mountain cabin any time I chose for the next year, as long as it was available. I stayed there four times, and it was fantastic.

Let’s talk about what you’ve been pondering lately. Gimme a call at 619 889-7100 and we’ll chat. Have a good one.