Refinance for free money?
Today we are talking about a “time bomb” that that you might have planted in your real estate investment.
Have you done a refinance? More than one?
It’s possible that you could own your investment property for 15 years, refinancing during that period, and then when you sell the investment real estate, you might not have enough Net Sales Proceeds to pay the Capital Gains and Depreciation Recapture Taxes.
REFINANCE LOOKS LIKE FREE MONEY
When you take out a portion of your Equity that has built up in your investment property, it could have unanticipated consequences.
You could also be borrowing some of the money that the IRS already has a claim on, money that will owe the IRS in the future.
Let’s look at an Example.
You bought a small Apartment Building 15 years ago for $500,000.
It has increased in Fair Market Value (FMV) and is now worth $2,000,000.
Over the years, as your Equity grew, instead of selling, you just refinanced.
You did this because you did not want to pay the Capital Gains Taxes that would be triggered by a sale.
You knew that the new loan proceeds would not be taxable as income, and you felt like you were getting your Equity out tax-free, doing a refinance for free money.
Fast-forward to today.
You are ready to retire and move to the beach, and you plan to sell the Apartment Building for $2,000,000 and cash out.
You figure you’ve already received your profit over the years, tax-free, by getting the loans, and now it will just be a matter of settling up, and closing the books.
You could be in for a surprise.
REFINANCE IS NOT FREE MONEY
First, let’s look at what your Net Cash will be from the transaction, both pre-tax Net Cash and after-tax Net Cash.
Your Transaction Costs will be:
- Real Estate Commission: $100,000.
- Survey, Title Policy, Inspections, Escrow, and Closing Costs: $40,000
- Legal costs and document prep: $7,000
- Escrow for updates and repairs: $23,000.
So, your Transaction Costs will be about $170,000.
That means that your Net Sales Proceeds will be $1,830,000.
Now, you must pay off the debt on the property.
Over the years, your Lender has allowed you to refinance 85% of the Fair Market Value of the property, because you are willing to cross-collateralize other investment property, and because you are willing to sign an Assignment of Rents to cover the Lender in case you start to miss payments.
So, your Mortgage Payoff amount is $1,170,000.
That means that your Net Sales Proceeds at Closing will be $130,000.
This is referred to as your pre-tax Net Cash position.
You feel Ok about it because you have been pulling out your profit over the years with the refinancing, and the money has been tax-free.
Your plan has been to refinance for free money.
But now it is time to settle up with the IRS.
TIME TO PAY THE PIPER
Your Net Sales Proceeds of $130,000 will probably have to be used to pay some or all of your tax liability for Capital Gains and Depreciation Recapture.
First, we have to calculate your Depreciation Recapture Tax, which is assessed at your Marginal Tax Rate, up to a maximum of 25%.
In this case, we assume that it will be 25%.
Let’s look at your Depreciation Recapture.
You originally paid $500,000 for the property. You assigned $70,000 as the value of the land, which is not depreciable, and you assigned the remaining $430,000 to the value of the building and ground improvements.
You put the $430,000 on a Depreciation Schedule with a 27.5 year depreciation period, resulting in an annual Depreciation Allowance of $15,636.
You owned the property for 15 years and claimed total Depreciation of $234,545.
Your 25% Depreciation Recapture Tax liability is $58,636.
Now, let’s look at your Capital Gains situation.
Although you paid $500,000 for the property, you have claimed Depreciation of $234,545 and that reduced your Basis in the property to $265,455.
Your Sales Price less Transaction Costs, your Net Sales Price, is $1,830,000.
Subtract your Basis from your Net Sales Price and your Capital Gains is $1,564,545.
This will put you in the 20% Capital Gains bracket.
So, your Capital Gains tax will be $312,909.
But we are not finished.
Then you have the 3.8% Obamacare Tax on investments of $59,453.
All three taxes together total $430,998 in tax liability.
So, your $130,000 Closing check is not going to help very much.
You’re going to need to come up with another $300,998.
It is good business to get that Equity out of you investments, if you are planning to use it as a down payment to leverage other real estate investments.
That’s how you accumulate wealth.
But if you are taking that Equity out and spending it to improve your lifestyle, that’s great, but just be aware that about 20% of that Equity is not yours to spend, it represents what you will owe the IRS.
Set that aside, and you won’t be suddenly faced with a disaster like we just described.
I touch on this same concept in more than one of my books, but the one with the most detailed information is “Do This, Not That.” If you would like to preview it, you can go here on this website to look at it first, use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
And, if you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then you should start with a Dictionary, and I have done one, in 3 separate Blog Posts here: Part 1, Part 2, and Part 3. And I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
And if you think you might like to read one of my books, but can’t decide which one, here are four that I recommend.
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