The MacRo Report Blog features some tax insight from guest writer Paul Steckel, CPA
So you purchased some investment real estate during the “good times”.
Now you may have noticed that the times are not so good anymore. The value of your property may now be less than you paid for it.
Hopefully you have the “Staying Power” to cover the carry costs of the property until the markets turn bullish. If not, you may be looking at more than a haircut on your investment; you could be also looking at an income tax liability.
Most real estate investments are organized as tax partnerships, so the income taxation of partnerships and partners could be relevant to your situation.
Say you bought the property for $1million in year one using $200, 000 of equity and $800,000 of debt. In years two through four the property increased in value by $200,000 to $1.2million.
In year four you refinanced the loan for $1million, taking out an extra $200,000 in loan proceeds to acquire a piece of commercial real estate for sale (There are complex rules regarding the treatment of interest paid on debt financed distributions, which I won’t go into).
In the meantime, using IRS rules, you have been depreciating the property and have claimed a total of $100,000 in income tax deductions from years one through four.
Now it is year five and due to a serious down turn in the real estate market, the value dropped back to $1million. Things are not going as well as hoped in your ability to continue to cover the debt load, maintenance and taxes on the property; so you have made the difficult decision to sell it.
You figure if you can sell the property for $1million, you’d have enough proceeds to just about pay off the loan and essentially break even, right? Wrong. You have taxable income of $100,000 due to the and, accordingly; your tax could be as much as $40,000.
Why? Both the depreciation deductions and the debt financed distributions were not taxable in the year they were taken because you had basis in the debt securing the property.
Now that the debt is paid off, the chickens come home to roost. The $100,000 in depreciation deduction and the $200,000 cash distribution reduced your tax basis. That $300,000 effectively took back your $200,000 investment and created a negative capital account of $100,000. As a result, you have $100,000 less basis in the debt than its pay off amount. That’s taxable in the year the debt is paid off.
Paul Steckel directs the tax practice for the Frederick, Maryland office of McLean Koehler Sparks & Hammond, which provides business and individual tax planning and preparation, estate, succession and personal financial planning. He is a CPA and Tax Partner with the firm. Paul is a graduate of Gettysburg College.