Adjusted Basis: It Ain’t Just ‘Buy Low & Sell High’ For Real Estate Investors

Posted @ 8:24 pm - Filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Selling Income Property, Investment Lessons, Depreciation, IRS

Ever been to the gym for a workout and some guy with good intent tries to help you out? Has it occurred to you he doesn’t know any more about body building than your Aunt Fannie? We’ve all had that experience, if not at the gym, somewhere else with another subject. One of my all time favorite cousins is a nationally known and highly respected commercial photographer. One day he was taking some shots for a job while I was visiting. He nearly wet his pants when I tried to sound like I had the first clue about the ins and outs of what a professional photographer does and why.

After my third comment he was wiping tears while begging me to stop. I still say it wasn’t that funny.

When real estate investors do it though, it can be miles from funny when they act on their sometimes misunderstanding of various concepts. Here is one of My Greatest Hits — which if misapplied or misunderstood can have some fairly sour unintended consequences.

Adjusted Basis — Doesn’t this beg the question a bit? Wouldn’t it help to understand what a Basis is before we get into adjusting it?

First, you head over to the Basis Store. (Sorry, long day. ) When you invest in a real estate property — through a purchase, not an exchange — you establish your basis. Simply put, it’s what you paid for the property. It can get more complex than that, but suffice to say, your purchase price is your basis.

When you take depreciation (a phantom loss) it lowers your basis. When you add a physical improvement, a new roof for instance, you increase your basis. Upon the sale of that property your sales costs add to your basis. I won’t bore you with all the rest of the various potential basis adjustments here. Just understand when you improve a property your basis will probably rise, and when you take depreciation you lower it.

Why is it important to understand Adjusted Basis? Simple. Your capital gain/loss is calculated upon this concept. Many investors think they’re taxed based upon what they paid vs for how much they sold the property. In my experience, this gross misconception has been the catalyst for some very nasty surprises which usually come sans gift wrapping around April 15th. Once that horse is outa da barn, there’s no going back — a sale is a sale is a sale — and so are the taxes owed.

Here’s an example of a recent oops!

First, a couple quick definitions.

1. Depreciation — It’s a loss in the value of an asset, in this case real estate. However, since real estate historically rises in value, this loss is really not ‘real’ — it’s a phantom loss. The investor, with some limitations and/or exceptions, is allowed to take this phantom ‘loss’ against the income of the property and if there’s any left over, against his job income — which is called ‘ordinary’ income.

2. Recapture — When an investment property is sold, and the taxpayer has taken the allowed deductions against their ordinary income over the years the investment property was held, the accumulated amount of depreciation used (deducted) by the taxpayer will be ‘recaptured’ and taxed as ordinary income. (ouch!) Note: This tax rate is much higher than that applied to a long term capital gain.

An investor paid $300,000 10 years ago for a fourplex. During the holding period he took a total of $120,000 in depreciation. He made no improvements to the property, i.e. rooofs, additions, etc. However, three years ago he refinanced the property for $700,000 — as he wanted to invest in more property and didn’t realize at the time a tax deferred exchange was the better way to go.

He sold the property towards the end of last year for $900,000 — (why, is anyone’s guess, since he wasn’t executing a tax deferred exchange) then called me at the behest of his son the Business Major. Fortunately the escrow had just been opened. That fact, along with his call, saved him many sleepless nights. (The sales price reflected the recent decline in values.)

I’m gonna oversimplify this massively to get the point across — so no kibitzing. Capital gain is taxed at a lower rate than depreciation recapture, as mentioned above.

When you subtract the $120,000 he took in depreciation then add his sales costs of $70,000 — his adjusted basis is about $250,000 or so. What’s the big deal you might ask?

He sold it for $900,000 which leaves him a (over simplified) capital gain of $650,000 or so. The total taxes he’ll owe on his next tax return could easily be $100,000 — give or take a few grand.

His net proceeds from the sale will be a little over $155,000 +/-. Ah, but wait a minute. He now owes the $100,000 in taxes — so his real world net is less than $60,000 from the sale of a property that sold for triple the price he paid for it.

Since he wasn’t my client, I didn’t pry into what he had done with the $400,000 in cash he received from his refi. If he didn’t invest it as was represented and this poorly thought out sale had proceeded to close, 10 years of solid investment would have been poured down the virtual drain. Not a happy prospect.

Allow me to pause here and shine a bright light on one huge factor missing here: Nowhere could I find even a thread of any kind of Purposeful Planning. This is what happens when an investor just decides to buy and sell without a Plan. It can become a little hairy at times.

Fortunately he called our office before his sale closed. We advised his agent, using his CPA as a conduit, to turn the sale into a tax deferred exchange — which was done immediately. He’ll now totally avoid — ah, read defer — those taxes. To be fair to his agent, the guy begged his investor client to get tax advice, but the guy wouldn’t listen. We’ll never know why.

I’ve seen several cases where the net proceeds of a sale weren’t even enough to pay the capital gains taxes owed. Imagine being a real estate investor receiving that sorta surprise.

The moral of today’s story is this: It’s so often true — Buying low and selling high has no relationship to basis and adjusted basis. The government will almost always say your profit is far higher than what reality (and the net proceeds check from escrow) tells you.

Knowing your adjusted basis is always part of any Purposeful Plan. A tax bill should never be a surprise.

The government’s plan for your capital gain is already in place.

This entry was posted on Thursday, March 20th, 2008 at 8:24 pm and is filed under 1031 Exchanges, Real Estate Investing, Purposeful Planning, Selling Income Property, Investment Lessons, Depreciation, IRS. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.