Debt over Basis – When Your Loss Becomes Gain
During the past several years some investors have been hit with a rude surprise; their losses have become gains. So how does a total loss such as a foreclosure trigger a gain?
It is critical to understand that gain has nothing to do with profit, or net equity; it is the result of a calculation. Here’s a brief overview:
What Is Gain?
Gain is simply the adjusted sales price minus the basis.
What is the Basis?
The basis is the purchase price plus capital improvements minus depreciation.
The “purchase price” can be different than the actual price paid for a property if the property was acquired via a 1031 exchange, received as a gift, inherited or acquired in some other tax deferred manner. Improvements done to the property that have been capitalized will increase the basis and depreciation taken will decrease the basis.
In a foreclosure the property is lost so how can there be gain? In a foreclosure the “sales price” is considered to be the debt on the property. If the debt is greater than the basis (often referred to as “debt over basis”) there will be gain upon a transfer. A simple example is a person whose basis is $150k with debt of $250k. Since the debt would be treated as the sales price we have $250k-$150k netting $100k of gain. In a foreclosure the taxpayer would have lost all equity and the property yet have a gain and tax exposure.
A 1031 Exchange can be structured in order to defer any gain you may be exposed to. We often have Exchangers who choose to complete an exchange using the money that would have been the taxes due as a down payment for a replacement property. With today’s economic climate you might find yourself unwilling or unable to fully satisfy exchange value requirements, it is possible to partially satisfy the value requirements deferring a portion of your gains. In a nutshell anything spent beyond the basis represents tax deferral; if the basis is $150k and you spend $200k you would have deferred taxes on $50k in gain, acquire the property that works for you because it is not an all or nothing decision.
Do not hesitate to contact Equity Advantage with any questions or concerns you may have! We look forward to having the opportunity to help in any capacity we are able. Our office can be reached at (800) 735-1031 or via email firstname.lastname@example.org.
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