Thursday, March 12, 2009

A Sad, But All Too Common Story

In past years, the most common situation was people nearing retirement often came to a decision to sell real estate or businesses which had appreciated in value, had a low cost basis and little debt. This left a big gain and a huge tax bill.

There are still many great choices for deferring or spreading out taxes over long periods of time and setting up a solid income stream for retirement if this is the case.

With this crazy economy, more and more upside down situations are becoming all too common place. Here is one scenario which has many variations, but the same dire consequences.

Phil bought a commercial property 16 years ago for 500K. As it appreciated in value, he took out equity to make other investments, pay bills and buy a few luxuries. His debt increased to 800 as the property value reached 1 million.

Then the market came tumbling down and the property is now worth 750K and he wants to sell. He will only clear about 700K after normal costs of sale. He called to ask how he can minimize his taxes.

Phil is in a world of hurt with no good way out. Not only would he have to come up with 100K out of pocket to pay off the loan to the lender, he is on the hook to the IRS for 400K in capital gains and depreciation recapture, which will work out to about 120K in taxes due.

So, to sell now, he will owe approximately 220K out of pocket to the bank and the IRS and he will have zero proceeds from the sale. Phil was hoping I would have a solution for him to defer paying his taxes. Bankruptcy came to mind.

The thing Phil was oblivious to was that he had had use of 300K equity for many years, but had not reinvested it into his property, and spent it elsewhere. He had assumed the property value would continue to increase and never go down. Now he’s pretty much up a creek without a paddle.

Since Phil does not have the money he needs, he may not be able to sell at current market value. The lender would have to ok a short sale, and then he would have to declare the 100K as income because it is forgiveness of debt and there is no break for investment property. He would still owe the 120K to the IRS. There is no way he can pay all his tax and mortgage obligations, as he has no savings.

The bottom line is, Phil is in trouble and if he can’t hold onto the property he will have to look into bankruptcy or insolvency. There are currently many in the same boat and there is no good way out. I hope Phil can hang on until the market rebounds at least enough to cover his taxes because I hate to see anyone lose everything they’ve worked for.

Paula Straub
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