Ever walked into a movie you’d really been lookin’ forward to, only to learn they’d totally mislead you with the trailers? We all have, and with an exception or two here and there, it rarely turns out to be a movie we like. Don’t ya hate it when the happens? For me, the worst time was when I went to what I thought was a comedy, which sadly turned out not only NOT a comedy, but a chick flick to boot. How it got past my ChickFlickRadar™ I’ll never know. 
This is one of those nuts ‘n bolts things every real estate investor should know. The IRS doesn’t usually buy the whole ‘dog ate my homework’ — ‘I had no idea’ type of excuse when it comes to unintentionally recognized capital gains. So, heads up.
Here’s a way you’ll possibly experience what I’ve termed Stealth Gain.
Let’s say you bought a property some time ago. The boom generated two things — an increase in value — and your Happy Feet dance which came immediately afterward. Now though, you’ve been clotheslined by the market correction. Your property’s value zoomed — then came back down to earth with a rough landing.
When times were goin’ your way, you refinanced. For this discussion, the reason isn’t relevant. The loan amount was for quite a bit more than you paid for it. Also, your adjusted basis — basically what you paid, plus any sales costs and/or capital improvements, minus all the depreciation you took while you owned it, was far less than the loan balance at sale. And before you ask, NO, it doesn’t matter if it’s a foreclosure sale or a short sale. If you’re mortgage over basis, you’ll have a capital gains tax to pay. (And I haven’t even brought up the whole ‘debt forgiveness’ nightmare.)
Why am I tellin’ you this?
Simple, if you sell for what you think is a very small gain, or even a loss — even through foreclosure or a short sale — you still might discover you owe taxes.
I won’t go through all the ins and outs here, as it would go on forever. Suffice to say, it’s very possible to walk away from a sale with $1.98 and still owe capital gains taxes on a sizable ‘gain’. If your loan was $100,000 over your adjusted basis, regardless of any subjectively perceived profit or loss, you’ll be scramblin’ next April 15th to deal with it. See what I mean about Stealth Gains?
Here’s another way you can get bushwacked.
The same thing goes for those of you selling for what you naturally think is a very small gain, or even a loss. You may actually be bringing in your own cash to close the escrow. Yet — WARNING: Here comes another clothesline. If your adjusted basis is lower than your sales price, you’ll be recognizing a capital gain. This time though it could be couched in terms of the depreciation you may have taken during the holding period. They’ll call it ‘depreciation recapture’, though there may indeed be a cap gain too. For the record, tax rates for ‘recapture’ are higher than cap gains rates. Just so ya know.
This often happens when an investor acquired the offending property via their third (or fourth, or fifth) tax deferred exchange. This results in two consequences — neither one of which is good if you’re selling, not exchanging.
1. Each time you exchanged, your adjusted basis, which is almost always smaller than the day you acquired the property being left behind, went with you to the next property(s).
2. Over the years (and exchanges), each year of depreciation makes that basis smaller and smaller.
So when you bought it for $100 back in the day, executed a few exchanges, the last one at an acquisition price of $300, your ultimate sale will cause problems. Here how: You sold for $295, which meant after your costs of sale, the net check you received from escrow was enough to take the family to 31 Flavors for double-dip waffle cones. HOWEVER — since your adjusted basis at the time of the sale was the proverbial ‘buck-three-ninety-eight’, you can readily see what’s next.
See, your adjusted basis was WAY lower than your $295 sales price, which means you just entered The Twilight Zone — episode title, Nightmare on Cap Gains Street. And yeah, I know the sales price was less than you paid for it.
BawldGuy Takeaway: The cash you net from a sale has no connection whatsoever to the reality of how your capital gain will be computed. Before you have even a semi-serious thought about selling, PLEASE PLEASE PLEASE consult with your CPA. Don’t have one you think knows the ins and outs of this stuff? Not to worry — gimme a buzz and I’ll hook you up with someone who knows which way is north on the map.
Contact me at 619 889-7100. Have a good one.
Related posts:
- Realizing Big Time Capital Gain — Payin’ Little Or No Taxes — How He Do Dat?
- Adjusted Basis: It Ain’t Just ‘Buy Low & Sell High’ For Real Estate Investors
- What a Lifetime of Tax Deferred Exchanges Can Lead To — It Ain’t All Good
- The Facts About a Strategy For Offsetting Capital Gains – Not To Mention Steering Clear of Taxes
- A Kinda Sorta Case Study In The Making — Turning Lemons Into Mojitos
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