Many investors purchased homes based on speculation of appreciation, and their rental properties produce negative monthly cash flows. Austin is one of the best real estate marketing in the country. However our market is not immune from the national housing bust. Most real estate values have dropped, and many investors can’t afford to pay the monthly negative cash flow on their rental property. Some investors are selling homes if they have equity while other investors are selling homes in a short sale transaction or allowing home to go into foreclosure. Allowing a home to go into foreclosure can result in a large income tax bill.
Anytime a seller sells an investment property, he or she is subject to capital gains tax and depreciation taxes. The IRS allows an investor to depreciate the improvement of a single family residence rental property for 27.5 years. Below is a simple calculation for yearly depreciation:
Purchase Price $125,000
Land Value – $25,000
Improvement $100,000 / 27.5 years = $3,636.36
In the above example, an investor depreciates a rental property $3,635.36 each year. If investor does not do a 1031 exchange and reinvest 100% of sales proceeds to purchase another investment property, he or she must pay a flat 25% tax for each year the property was depreciated. If owner owned property for ten years, he or she would owe $9,090 in taxes for depreciation deductions. This tax does not include capital gains tax.
Currently, the long term capital gains tax is 15%. However, the capital gains tax most likely will increase next year as tax laws change and the new Obama health care plan is implemented. Capital gains taxes are a separate tax and calculated independently of a depreciation expense. Most homeowners living in a home as their primary residence are usually not subject to paying a capital gain assuming they lived in the home three out of the last five years and the gain is less than $250,000 for individuals and $500,000 for a married couple. This exclusion does not apply to investors.
Many owners and investors are unaware the lender can 1099 the borrower for unearned income if home goes into foreclosure, and lender is not able to satisfy the principle mortgage balance. For example, if the lender sells property for $15,000 less than what is owed on a mortgage the lender can send a 1099 to the borrower for the amount of the $15,000 loss. The borrower will be responsible for paying personal income taxes at his/her current tax rate.
If an investor recently pulled cash out of property and has owned home for many years, the foreclosure can result in a capital gain tax, depreciation tax, and unearned income tax. We have seen investors pull cash out of a rental property, and the home depreciate in value putting the owner in a negative equity scenario. However, capital gains taxes are calculated based on the cost basis and the selling price and selling costs. The foreclosure sales price may be higher than the cost basis resulting in a capital gains tax and 1099 being issued to borrower.
In summary, allowing a home to go into foreclosure may seem like a quick fix. However, we advise all investors to analyze the tax consequences of paying a capital gains tax, depreciation tax, and unearned income taxes if home results in a loss by mortgage company. Please consult your CPA or financial advisor for details.
If you have any questions, please call us at 512-257-9836. Our office provides sales, leasing, property management, and mortgage services.