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Discussion:Selling an underwater rental

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Discussion Forum Index --> Tax Questions --> Selling an underwater rental


BFStax (talk|edits) said:

21 March 2014
Client converted personal residence to rental in May 2011. Since then it has been one enormous headache, and she just wants out. Unfortunately the bank just denied her short sale request because she makes too much money, but she wants to sell anyways. This means she has to come to settlement with $105,000 of personal money, which she will take from IRA (early withdrawal, 10% penalty). Rental has $6,000 of carryover losses, $6,000 of current year expenses. 1231 loss on the property ends up at only $15,000 (after taking into account depreciation recapture of $15,000). How will the $105,000 be treated? The only way she can sell the house is if she can offset the ordinary income from IRA distribution with a loss, and I don't see how the repayment of principal on the mortgage can be taken on the return.

Kevinh5 (talk|edits) said:

21 March 2014
The 105K has no impact on her basis. She is just paying off debt.

What did have an impact on her basis was the FMV at the time it was converted to rental.

I don't know why 'the only way she can sell the house is if she can offset the ordinary income from the IRA distribution with a loss..'. I don't think that is a condition of sale. I think it is just her desire.

Kevinh5 (talk|edits) said:

21 March 2014
Oh, and how is there any depreciation recapture?

Kevinh5 (talk|edits) said:

21 March 2014
The client should probably talk with an attorney about abandonment. It may or may not be a potential solution.

BFStax (talk|edits) said:

22 March 2014
how is there any depreciation recapture?

Because she is nice and wants to pay the IRS more than she owes. Yes, there is no recapture on this loss.

Her basis at time of conversion was $145,000. $15k of depreciation, and she has a contract for $115; This is only a $(15k) loss.

'the only way she can sell the house is if she can offset the ordinary income from the IRA distribution with a loss.

This is not a condition of sale, but rather her choice. If she can't offset the income then she won't sell. She has the contract in hand but won't sign it.

Kevinh5 (talk|edits) said:

22 March 2014
you use the term 'can' very liberally

I use it literally. As everyone can see.

oops, I was just corrected by a Miss Anne Sullivan. My apologies.

BFStax (talk|edits) said:

22 March 2014
Well, the only way she CAN sell it is if she could offset the ordinary income from IRA, because she CAN'T afford the tax on $105k.

BFStax (talk|edits) said:

22 March 2014
But I did tell her about possible abandonment and that a lawyer would be able to help more, but she is in a recourse state so I don't know how often banks actually sue.

Kevinh5 (talk|edits) said:

22 March 2014
I would think that she CAN sell it and not tell the buyer about her tax woes. Dealing with them next year and setting up an installment agreement, for example.

BFStax (talk|edits) said:

22 March 2014
Haha, I guess it's all semantics.

Ckenefick (talk|edits) said:

22 March 2014
I know what you meant..."can" as in "can to afford."""

Someone buys prop for $300k, say fully leverage. Prop drops in value to $200k. It's converted to a rental. Prop is sold for $200k, it's value. No tax loss, yet, client needs another $100k in cash to pay off the mortgage.

You indeed have a problem here, BFS. Really, what's happened is that she used leverage to buy a personal asset. The value has dropped, but not her obligation on the bank note. And the value drop is personal in nature and is not deductible. In my example, we have to use the $200k as the tax basis of the property. It all makes sense.

Kevinh5 (talk|edits) said:

22 March 2014
My 7th grade English teacher, Mr. Thomas, got the point across to the entire class.

When a student raised his hand and asked "Can I go to the bathroom?" Mr Thomas would stop and look in horror "I certainly hope you CAN. Now maybe you'd like to ask whether or not you MAY?"

Ckenefick (talk|edits) said:

22 March 2014
...and then the kid crapped in his pants and everyone laughed at him.

Ckenefick (talk|edits) said:

22 March 2014
the story of my life...

Ckenefick (talk|edits) said:

22 March 2014
click on the dots to see this underwater rental:

http://www.jul.com/InsideJules.html

STG (talk|edits) said:

22 March 2014
Doesn't walking away create almost as bad a situation due to cancelled debt (assuming they don't come after her for the difference.)

Obviously better than touching her IRA for this - STOP!!! Sorry, couldn't help it.

But, like I said, this is a bad tax situation no matter which way she did it. It's an object lesson that if short sale or foreclosure is even a remote possibility, do it BEFORE you convert it to a rental. At least then you MIGHT get personal residence exclusion (depending on what we finally decide "personal residence at time of foreclosure" really means.

Kevinh5 (talk|edits) said:

22 March 2014
Aren't IRAs protected from bankruptcy? It could very well be bad advice to advise her to cash in her IRA. That's why I suggested she talk with an attorney.


And yes, Chris, actually the kid did go to the bathroom in his pants. Just to teach Mr. Thomas that good English doesn't trump a full bladder.

BFStax (talk|edits) said:

22 March 2014
I feel bad for this client because she has no debt. No credit cards, no student loans, nothing. Except the mortgage, which she's short on for the current contract. And she just wants to move on with her life. Unfortunately for her she is either taking a huge tax hit, or risking obliterating her credit rating.

Harry Boscoe (talk|edits) said:

22 March 2014
Just for the record, if there's no gain on the disposition of a piece of depreciated real estate, can there be [oops .. might there be] any "depreciation recapture"? For that matter, can there be [oops again] any "depreciation unrecapture" if there's no gain?

Southparkcpa (talk|edits) said:

22 March 2014
Kevin's point is key. Her basis is the lower of cost or FMV on conversion date ..SO... her loss on the sale may be economically big, but from a tax standpoint it may be insignificant as the decrease in FMV occurred well before she converted to rental.

BFStax (talk|edits) said:

23 March 2014
Kevin's point is key. Her basis is the lower of cost or FMV on conversion date ..SO... her loss on the sale may be economically big, but from a tax standpoint it may be insignificant as the decrease in FMV occurred well before she converted to rental.

This is exactly the point. FMV at time of conversion was only $145,000 and after depreciation her basis is only approximately $130,000. Contract is for $115,000 so tax loss is only about $15,000, BUT mortgage still has a balance of $225,000. So she is trying to figure out how to get out of this because it is nothing but headaches for her.

Ckenefick (talk|edits) said:

23 March 2014
Where is her primary residence in relation to her rental - same city?

Ckenefick (talk|edits) said:

23 March 2014
Also, what would happen if she contributed this property to a wholly-owned Subchapter S corporation?

Frankly (talk|edits) said:

23 March 2014
"So she is trying to figure out how to get out of this because it is nothing but headaches for her."

Hire a top-rate property manager to manage the headaches.

STG (talk|edits) said:

23 March 2014
Frankly may have the best idea yet.

Ckenefick (talk|edits) said:

23 March 2014
I was about to really give it to BFS's entitled client, after that "headaches" comment, but I held off, but now that Frankly has started in on it...

I asked about the proximity of her rental to her current residence. If in close proximity, why not sell the current residence (if she owns a current residence) and then move back into the rental. And then just suck it up. Just keep paying on the mortgage. After all, didn't she promise to do just that - pay on the mortgage? I bet that's what the promissory note says. And, who knows, maybe property will appreciate over time.

Why did she move out in the first place? She just wanted something bigger and better or what? Now this promissory note has become an inconvenience?

Why doesn't she make an offer to the bank? Ask the bank to accept the $115k + $50k of her own cash, or something like that.

BFStax (talk|edits) said:

23 March 2014
Hire a top rate property manager to manage the headaches.

For starters, that costs money. But it is an idea she considered if she couldn't take the loss. As for the location, it's on the outskirts of a big city and I don't think it's very safe.

Ckenefick (talk|edits) said:

23 March 2014
Where does she currently reside - in the city?

Ckenefick (talk|edits) said:

23 March 2014
And, does she own her residence?

Kevinh5 (talk|edits) said:

23 March 2014
Paying the tax on COD income costs less in dollars than cashing in her IRA and paying the tax and penalty. And she'll still have her IRA.

Kevinh5 (talk|edits) said:

23 March 2014
Oh, I get it, there is no guarantee they will cancel the remaining debt. Well, they can't force her to cash in her IRA, so I'll bet they'll eventually accept something less than the full balance.

Ckenefick (talk|edits) said:

23 March 2014
Exactly, make them an offer, unless the OP taxpayer just doesn't have time to do that, with this whole thing being a headache and all...

Ckenefick (talk|edits) said:

23 March 2014
I still want to know where she lives and if she owns the place where she lives.

BFStax (talk|edits) said:

24 March 2014
Oh, I get it, there is no guarantee they will cancel the remaining debt

Exactly. They just refused the initial short sale offer because she makes too much money. It's a catch 22 because if she stops paying the mortgage her credit is destroyed. Pay it off personally and she can't afford the tax consequence. My belief is that she should suck it up and keep renting it out. At least for another year or 2 and hopefully the value picks up.

I still want to know where she lives and if she owns the place where she lives.

I believe she is currently renting and I don't know her current location.

Ckenefick (talk|edits) said:

24 March 2014
How are you going to do her tax return if you don't know her address?

Ckenefick (talk|edits) said:

24 March 2014
It's a catch 22 because if she stops paying the mortgage her credit is destroyed.

And wouldn't it really suck for the poor gal if her credit gets destroyed AND the bank sues her AND wins and has a judgement against her...that she might end up having to pay?

BFStax (talk|edits) said:

25 March 2014
How are you going to do her tax return if you don't know her address?

Kevin is going to love this one... She isn't officially a paying client yet. I used that term liberally too. She is a friend of a family member who came to me for advice. So no, I am not preparing her return and therefore some of the details I didn't ask.

Ckenefick (talk|edits) said:

25 March 2014
Oh, ok, because the first word of your post was "client."

Not all that surprising that she's not a paying and is asking for free advice. After all, her upside down residence, which she just converted to a rental, was just a headache for her, so she wants the bank to eat her loss.

Kevinh5 (talk|edits) said:

25 March 2014
Yup, you get blasted on this one. Why do people feel it is OK to waste our time on 'hypothetical' maybe would-be might become clients?

I'm glad to help you earn a living, but I'm not here to have my time wasted on people who aren't even helping you OR I to earn our livings.

Ckenefick (talk|edits) said:

25 March 2014
I don't mind the hypotheticals so much...it gets us thinking about stuff.

I don't mind helping people out either...

But in this case, BFS doesn't really know the person all that well. And I think the feeling some of us are getting from is that we have a person here that feels somewhat entitled. She'll only do the deal if it works out for her. Things go south so she moves out...and, she probably moved to a place that was convenient for her lifestyle. She wants the bank to eat her loss. She wants out of the house because its a headache, she wants to retain impeccable credit and she doesn't want to have any tax shortfalls. And she doesn't want to pay for any advice. She basically wants to make zero sacrifices and have zero accountability:

The only way she can sell the house is if she can offset the ordinary income from IRA distribution with a loss

It is apparent that this person doesn't need a tax lesson, she needs a life lesson. These are not good clients to have. They pretty much appreciate nothing.

Kevinh5 (talk|edits) said:

25 March 2014
And suck the life out of every tax professional they encounter.

Death&Taxes (talk|edits) said:

25 March 2014
These people go around looking for those who wear their heart on their sleeve.

Ckenefick (talk|edits) said:

25 March 2014
Do you guys (or BFS) really do these kinds of consults for free?

There is no way I would. One of the first things out of my mouth is my hourly rate. If I sense a concern, the conversation is over.

Kevinh5 (talk|edits) said:

25 March 2014
It's easy to do them for free if you don't know the answer, Chris.

Ckenefick (talk|edits) said:

25 March 2014
Free Advice

Free Chat

Nilodop (talk|edits) said:

25 March 2014
It's easy to do them for free if you don't know the answer Got that right! Especially when you are retired. So what if the answer is wrong? Sue me.

BFStax (talk|edits) said:

25 March 2014
Wow, some of the above responses are just heartless. Yes, I used the word client, which by the way doesn't automatically mean they are paying. And by the way, Kevin, how am I wasting your time? You are not obligated in any way to answer these questions. Second, it is a close friend of my family's and I do know this person, just not every single aspect of her life so some details I'm hazy on and at this point in the season I didn't have time to spend hours figuring out her address, why she moved, blah blah blah. She is simply trying to find the best way to legally reduce her tax liability, which all of us on this website say is our job. If this was a random person calling I wouldn't have spent this much time on it but again, it's a family friend.

Maybe it's just that it's nearing the end of tax season but the reason I stay on this site is because of the knowledge everyone has to give, not the smart ass answers Kevin always makes.

And CK, I do appreciate your always being willing to help answer my questions.

Ckenefick (talk|edits) said:

25 March 2014
I think you gotta know the whole person here. My take is that she is single. Single people aren't tied down. If a mid-point offer to the bank won't work, why not just continue paying on the mortgage and move back in? After all, that's what she signed up for.

Sounds like she moved just to separate herself from her obligation. Doesn't sound like she's sick, had a job transfer, lost her job, etc.

Probably has a downtown apartment, friends nearby, a social life, etc., that was more important. No sacrifices by doing all that. Maybe get a loan from a family member. Of course, repayment will involve a sacrifice too, but maybe a better interest rate than the bank. Maybe stop the 401k deferrals. The effect is the same as the IRA withdrawal - more taxable income...but she controls it and does it over time, over a period of years. No 10% penalty to boot. All the 401k deferral money can go straight towards mortgage principal, perhaps making a mid-point offer more attractive to the bank. Plus, maybe some appreciation.

Sometimes, people don't want or like the hard answers, but you gotta give it to them anyway. This person seems to run her life based on a sense of entitlement and running away. I know plenty of people living in their underwater houses who would like to reside elsewhere.

Instead of saying, "Purely from a tax standpoint, your basis is the lesser of FMV or cost upon conversion...therefore..." Maybe you should tell her that, absent an agreeable bank offer, some sacrifices will have to be made (along with a wholesale change in her attitude). If she's not willing to make any, so be it. At which point, any future time you spend on her is a waste of time.

BFStax (talk|edits) said:

25 March 2014
At which point, any future time you spend on her is a waste of time.

I was done spending time on her the second I said "consult a lawyer about possible abandonment." And you're right about trying to find the easy way out. I never said otherwise. She got herself into this mess and she needs to suck it up and deal with the consequences.

DaveFogel (talk|edits) said:

26 March 2014
The problem many borrowers experience in negotiating with a lender for a short sale is that the lender insists that the borrower provide a financial statement. If the financial statement discloses that the borrower has sufficient assets to pay off the debt, then the lender won’t consent to the short sale.

The potential client should contact a real estate attorney to advise her as to the best option available to get rid of the property, either abandonment, foreclosure, or deed in lieu of foreclosure. In some “recourse states,” a lender is prohibited from obtaining a deficiency judgment after a non-judicial foreclosure or a deed in lieu of foreclosure, which means that the remainder of the debt is canceled by operation of state law.

If, for example, the lender consents to a deed in lieu of foreclosure along with agreement to waive the deficiency, there will be COD income. For a solvent taxpayer, that COD income might be excludable using the Qualified Real Property Business Indebtedness (QRPBI) exclusion. If the property was a personal residence and converted to rental use where the FMV at the time of the conversion was less than original cost, the QRPBI exclusion might be very valuable. For an example of this, see “Myth #4” of my article, “Ten More Myths About the Tax Consequences of Foreclosures and Short Sales”.

Gazoo (talk|edits) said:

27 March 2014
This question is far, far ahead of its time, and will one day be seen as a taxalmanac classic. Why? Because a lot of the rental property on America's coasts will be in fact underwater (I mean really under the water) at some point in the future and there will be a great deal of interest in renting it out, though the question of just who will want to RENT it is an entirely different matter.

I realize that the OP was speaking about someone who was underwater on a deal, but I just want to point out a question (in its very genesis) that will undoubtedly become a TA classic, and perhaps sooner than some of us think.

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