Found A Deal... But Seller Has Depreciated The Asset Too Much

20 Replies

I have found a deal that I would like to wholesale in Phoenix, AZ.  I want to help out the Seller as best I can with her situation, although I am in need of some advice in how to best assist her.

The owner is interested in selling the property, and is willing to sell it at a price that I feel is a great deal.  Although, she is concerned that she has owned it for so long as a rental, and has depreciated the asset so much, that she feels her tax bill on the captial gains will be so high that she will actually lose money when she sells the property.

The owner inherited the property back in 1979 with no mortgage on it.  Then she proceeded to depreciate the asset for the full 27.5 years available.

Any tips or ideas to help her out?

Not a tax attorney or CPA... but from what I understand I think your initial thoughts are correct. That being said it may be long term capital gains tax which j think is 15 percent.

Talk to a CPA

Not really, because I don't really get her issue. She received an asset for no money and no diligence on her own part. She rented it out (why else would she have depreciation?) for the last 37 years and made all that money on rent. Now she stands to have a huge capital gain on the property and she's going to have to pay back the depreciation (which never existed, in the eyes of tax law, since the property is being sold for a profit). 

I don't get where she "loses" money. She didn't pay for it in the first place and used it as a cash-producing vehicle for almost 40 years. I get people wanting to minimize their taxes, but in her case she just doesn't want to pay any taxes. 

Tell her to sell the property and carry the note herself. 

can she 1031 it so she doesn't "lose" money....

@JD Martin exactly.  I can understand that she wants to limit her tax liability, but she has definitely made her fair share of money over time.

I have urged her to speak with a CPA/Financial Advisor regarding the ability to 1031 the property.  

Also mentioned the idea that she could carry the not to avoid paying such a large capital gains bill.  Although, not sure if it would work out in conjunction with me wholesaling the property as my potential Buyer would want to flip the property to an end user who would most likely get a new loan and pay her note off... 

Would she still have to pay a capital gain if she carries the note and then her note is payed off from another Buyer?  Never had experience with this before, but I am assuming the answer is yes...

@Matt K. Working that idea with her.  Have urged her to speak with her CPA/Financial Advisor.  That way she could exchange to a more convenient property closer to her and easier to manage...

Originally posted by @Chris Pike :

@Jd Martin exactly.  I can understand that she wants to limit her tax liability, but she has definitely made her fair share of money over time.

I have urged her to speak with a CPA/Financial Advisor regarding the ability to 1031 the property.  

Also mentioned the idea that she could carry the not to avoid paying such a large capital gains bill.  Although, not sure if it would work out in conjunction with me wholesaling the property as my potential Buyer would want to flip the property to an end user who would most likely get a new loan and pay her note off... 

Would she still have to pay a capital gain if she carries the note and then her note is payed off from another Buyer?  Never had experience with this before, but I am assuming the answer is yes...

 Yes. Matter of fact I've heard a couple of podcast guests mention how bent some "carry the note" people were when they went and refi-'d out of the seller carry. That's the chance you take once you relinquish some rights to the property. 

You could increase slightly the negotiated price that you pay her to help her defray the tax costs of the sale. Perhaps enough of an incentive could be provided by you to her without making the deal prohibitive for yourself.    

@Chris Pike The property had a value in the estate when she inherited it. Her Capitol gains is based off of that beginning value. It doesn't matter how she sells the property she will owe 27.5 years of "recapture" Capitol gains is another matter. If she sells for less than the inherited value than there is no Capitol gains. Her only options are to sell using a 1031 to avoid some of these taxes. I'm no CPA but I think the recapture is due on sale regardless of whether or not she does an owner carry. That's going to be the bigger part of her burden if she sells with little Capitol gain and I believe it's due on sale. She needs to consult her tax person to be sure. RR

Originally posted by @Ralph R. :
 I'm no CPA but I think the recapture is due on sale regardless of whether or not she does an owner carry. That's going to be the bigger part of her burden if she sells with little Capitol gain and I believe it's due on sale. She needs to consult her tax person to be sure. RR

You should verify this but,

Yes - there will still be tax depreciation recapture for her if a note is taken back, plus the recapture amount is not eligible for installment sale treatment (i.e., assuming she takes back a note and at least some of the sale proceeds are received after the year of sale), so she would have to recognize the entire recapture amount in the year of sale and pay tax on it regardless of whether she takes back a note or not.

The remainder of the gain (i.e., above the depreciation recapture amount), if any, should be eligible for installment reporting.  

@Chris Pike @Christopher Smith What Christopher and I are telling you is she is going to need a big down payment to cover her depreciation recapture and closing costs. I don't know all the numbers but it's very likely it will greatly reduce the amount of money she will be able to carry. Couple that with a low sale price and she might be better off trying to get a full market price and paying the Capitol gain depending on her other finances. RR

@Chris Pike you keep referring to it as a "property." Of what type? Because if it's a run-of-the-mill 40+ year-old house, I wouldn't be surprised if her basis was <$50,000. If she depreciated $40,000 of that (excluding the land), then she owes the IRS $10,000. Her numbers will be different of course, but fully depreciating an AZ property from 1979 basis should not be a huge tax bill relative to the gain she will certainly realize. If there have been extensive upgrades that are on a different depreciation schedule, then you are less likely to be wholesaling it. It can't be land of any kind, no matter how valuable, because she wouldn't have depreciated that. Or maybe this is some dilapidated mansion screaming for a million-dollar makeover?

Maybe she's just shocked, as so many are, that there is such a thing as "depreciation recapture tax"? After all, investing in real estate is tax-free! Rich Dad told me this is 0% tax investing! Until the bill comes due, of course......

@Dan Schwartz that is what I was thinking as well.  It is just a small 1,600 sq.ft. home in Glendale that was built in the 60's.  She could not have racked up that much of a recapture bill.  I feel that she thinks that the bill will be bigger than it actually will be.  I have tried to present this fact to her.  Although, will keep trying to in conjunction with referring her to her CPA...

@Chris Pike a 1960s Glendale home? I revise my basis estimate down to $10,000. Just kidding...and being an East Valley snob LOL.

But if she's loathe to talk to her CPA about the tax implications of the sale, I'd guess she would have no appetite for seller financing or installment sales.

If it's a good deal and you have a little extra meat on the deal, up your offer $500 (or less) "to help with the CPA" and give her a check for her entire amount. Make it an easy transaction for her, as it seems like she doesn't want complications. Her tax bill is going to be her tax bill regardless of what you do, so just get title and you both move on.

Good luck!

@Chris Pike This is an instance where a 1031 Exchange can make a huge impact. If you have owned a rental property for a significant period of time, when you sell most investors end up paying somewhere between 30-40% in taxes. If you’ve depreciated the property the seller should expect to pay the IRS 25% of that depreciation back. Completing a 1031 Exchange allows you to defer that tax and depreciation liability and invest in another rental property.
To have a successful 100% tax deferred exchange there are a number of requirements the taxpayer must follow. The seller must trade equal or up in value, invest all equity from the sale and replace the debt, follow specific deadlines, enlist the help of a Qualified Intermediary to provide advice, prepare 1031 Exchange documents, and also hold the funds from the sale. Those are just a few requirements, there are others that are just as important.
If your seller wants to purchase another rental property and actively manage it, a 1031 may be a great solution for them. If your seller doesn’t want to manage another property, they can do a 1031 and invest in a DST, becoming a passive investor. If your seller needs some cash, she certainly can take some out and still complete a 1031 but should be prepared to pay tax/depreciation liability on the cash taken. I’ll pm you and see if you or your seller would like to discuss this option further.

@Chris Pike

Your seller needs to confirm with her tax advisor, but I believe only unrecaptured depreciation taken since May 1997 has to be recaptured.  If the seller had this property in service since 1979, most of the depreciation may have been taken before May 1997.  Thus, most of her sale profit would most likely be taxed as long term capital gain.  

@Chris Pike , The discussion has been valuable and spirited but I don't think her problem has been addressed.  I would venture to say that is part because she is used to a return and cannot reason that the return will change with either tax due or movement from active to passive investing.  She wants to sell but keep things as they were.  That's her problem.  Its a problem of perception not reality that's why you don't get it @JD Martin .  She hasn't been able grasp the obvious that you stated very well.

But you will never get anywhere until you solve her problem - whether it's real or not.  

I'm being counter intuitive here but I don't think offering more will "solve" her problem.  I think it will plant a seed in her  mind that the property is actually worth more.  She will focus on sales price and then will shift back to taxes owed - more sales price= more taxes.  I've seen this animal in the wild more than I ever hoped to.   You can't feed that spiral or you'll never get the property.

Owner carry may solve some attachment disorder that may be there but same issue as above - She'll be focused on the depreciation recapture up front (reasonable or not).  And then she'll be focused on the tax ongoing as payments come in.  It's not rational but it's real - she'll have a tax bill each year.

One of those monetized installments or deferred trust critters - I can't even get behind those even though I want to.  Try floating those out in front a non-rational thinking person with trust issues to begin with.  

The only way to solve her problem is to offer her the security of everything staying the same and somehow communicate that sameness to her.

The IRS gives her the option of the 1031.  But not into another build and grow asset - into a fixed income passive asset where there's good guarantees on income, no expenses, depreciation is never recaptured, no gain is ever recognized and she can pass it to her heirs and the tax goes away.  You need to get the actuals of her income statements and I'll bet there are products that would meet that.

Couple that with an intelligent conversation about risk and opportunity cost of selling without a 1031 or holding into a soft market.

Great point @Dave Foster ! I honestly believe a 1031 exchange is going to be the best solution for her, as it will accomplish her goal and she seems to be somewhat on board with the idea as well.  I know she would prefer to become a passive investor, does anyone happen to have recommendation on passive products that investors can exchange into?  @Lauren Speidel I am not too familiar with DSTs, any additional information on this option would be greatly appreciated.

Thank you all for your input!

@Chris Pike A Delaware Statutory Trust (DST) is an investment that someone would typically purchase through a Financial Advisor. Typically, the client must be accredited which means they have a $1M net worth not including their primary residence. The IRS views a DST as "like-kind" to other real estate. A Broker Dealer (sponsor) will set up a trust with their management team as the trustee. The sponsor purchases the property or properties and they create a portfolio of assets. The sponsor also secures the financing and makes all decisions on the portfolio (hence passive). The client would identify the properties in the portfolio and invest their exchange funds so that they are a percentage interest holder in the real estate. Typically, they receive a monthly distribution. Most sponsors these days are around 5-6% based off of equity invested. Most portfolios are around 50% leveraged and right now I've been seeing a lot of multi-family and healthcare offerings. I'd be happy to get you or her in touch with a trusted Financial Advisor to discuss what's available to review. Prior to working at Exeter, I worked for Inland Securities selling DSTs (Inland is a sponsor/Broker Dealer that has about 60% of the market share in the DST world). There are risks associated with a DST just like any other investment. For example, lack of liquidity or the distributions could stop (or increase). But, they can certainly provide benefits. Once the portfolio liquidates, the client can choose to invest in another DST (once again deferring tax), go into another property and actively manage it (again deferring tax) or take their cash (and pay the tax).

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