2 Nasty Tax Surprises For Many Real Estate Investors – And They’re Nothing New

by | BiggerPockets.com

One of the downsides to real estate prices rising and falling is how it can create anomalous circumstances for investors. When executing a tax deferred exchange, per Section 1031 of the IRC, the rules are fairly clear, and frankly, not all that complex. Many would have you believe how sophisticated and difficult they are. I offer myself has Exhibit A in rebuttal to that assertion. M.I.T. never recruited me. 🙂

The same goes for selling long term investment property. There are rules, as Grandma loved pointing out. All sales aren’t equal, as all 1031 exchanges are not. In fact, as many have learned the hard way some ‘losses’ are actually huge tax problems, and some exchanges simply were never tax deferred.

Let me be completely clear. It’s entirely possible for you to net next to nothing in a sale, yet owe taxes on large sums of money you don’t have, and didn’t receive from the escrow proceeds. Same goes with tax deferred exchanges. Proceed willy nilly, and you could very well discover first hand what ‘pretend’ cash is all about. As I said, the rules aren’t all that complex, so when we find ourselves in violation, it’s not hard to see, if you can do elementary arithmetic.

Still, don’t try this at home. The rules aren’t that hard to follow. But the when and why, along with the chosen investment strategy can screw things up like Hogan’s goat if you’re not experienced. My first several exchanges were closely monitored by both my CPA and one, sometimes two mentors. Simply put, don’t learn lessons the hard way with exchanges — or sales for that matter. Wanna know how you can believe me when I say that I’ve never had an exchange go bad?

I’ve still above ground. What would you do if my mistake cost you taxes on a half million dollar gain? The only question would be if they’d ever find the body. Badda boom.

A couple common mistakes when selling or exchanging real estate held for long term investment.

Let’s say you acquired a fourplex some time ago for $400,000, via a tax deferred exchange. Your adjusted basis when the exchange closed was around $290,000. Later on, for whatever reason, you decided at the height of the bubble that it was a great time to pull cash out, and put a $400,000 loan on it.

Then the market correction hit.

You become disgusted, and for whatever personal reasons, decide to sell the property. An offer materializes for $395,000 — you like it. Your loan balance at sale is around $360,000. Here’s the conversation I’ve had dozens of times over the last 35 years, when these circumstances are in place.

“Geez, Jeff, I won’t even net $1,000 when it closes. There’s no way I’ll owe any taxes!”

“Um, you don’t wanna know what the IRS will expect from you if you go through with this.”

Note: Due to additional years of depreciation taken, the new basis would be roughly $210,000.  The loan balance was pretty close to around $360,000. Oops. The IRS calls that, ‘loan over basis’. And yeah, I’m keepin’ this as simple as possible. The bottom line? The sales price was $395,000 — less than you paid for it years ago. But the new loan’s balance is around $360,000 — about $150,000 more than your current adjusted basis.

I want to reiterate that though the numbers are relatively simple, what’s true the vast majority of the time means that it’s not true all the time. There are always exceptions to every set of facts, and the IRS loves nothing better than to point out that sticky reality.

Resuming the conversation.

“What’d’ya mean what the IRS will expect?!”

“What I mean, Mr. Investor, is that if you go through with this proposed sale, you’ll most likely be on the hook for what the tax code calls ‘boot’. Bottom line? In your case it means you’ll have about $150,000 added to your job income, and pay at the ordinary income (job) tax rate.”

Weeping and wailing usually ensues at that point. Then the defeated look comes over their face, as reality begins to show its ugly countenance.

Time for one more very unhappy surprise.

Last summer you decided to to pull out a significant pile of cash by way of refinancing one of your high equity income properties. You cleared around $100,000 or so. Then a few weeks ago you found a great opportunity, and opted to execute a tax deferred exchange, which is scheduled to close the end of February. Oops.

‘Aw, come on, Jeff, what’s with the oops again?’

America is great, isn’t it? We’re all taught early on that we’re innocent ’til proven guilty. That virtually goes out the window with the IRS. We’re pretty much all guilty ’til we prove otherwise. In this case, what they’re likely as not to say, is that you pulled that $100,000 — wait for it — ‘. . . in anticipation of executing a tax deferred exchange soon thereafter. The cash you pulled out was your method of tax avoidance.’

So, for some reason they audit you. They see the refi happening roughly six months before you complete your 1031. At that point they begin so grin. They’re gonna declare that $100,000 to be ‘boot’, same as the first example. It’s gonna be added to that year’s personal income, and you’ll be taxed accordingly.

The best part about this so-called rule? There’s no hard ‘n fast time period that must pass between pullin’ out cash, tax free, from your income property, and an exchange of the same property. Nobody, including the IRS, can tell you what’s a safe time period, and what’s not. Don’t worry though, they’ll be fair. 🙂

There are all kinds of nasty little surprises awaitin’ real estate investors flyin’ solo, without an experienced, real estate oriented CPA as a co-pilot. ‘Course, having an experienced real estate investment broker tends to help too. 🙂

About 40% of the time, it’s my job to tell folks not to do whatever they’re planning. So much of the time, it’s the things we don’t do that yield the best returns.

Photo: MoneyBlogNewz

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

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