Selling rental property, investment property or commercial owner/user property via a short sale may still trigger capital gain taxes. The seller often focuses on the fact that they have no equity in the property and therefore assumes that they have no tax liability either. However, having equity or no equity has absolutely no bearing on whether they have a taxable capital gain in the real property.
This is an issue that many rental or investment property owners have probably not given much thought about. They own rental or investment property that is underwater (i.e. the real estate is worth less than what they owe on the loan). They have absolutely no equity in the property, or actually have negative equity. The property owner decides to try to sell the property via a short sale in order to mitigate their losses and get out from under the loan servicing requirements. Their lender agrees to the short sale, and they complete the transaction.
Investors Have Pulled Equity Out Over Time
The problem is created by the fact that the investor has pulled his or her equity out of the property over the years as the property has increased in value. The increased equity is gain that has been pulled out of the property, but they have not paid any taxes on the gain yet.
Let's use an example. Suppose that the investor acquired rental property for $100,000.00. It then grows in value each year. Each year the investor refinances the property and pulls out what ever additional equity is available. The value of the property reaches $1,000,000.00 in 2007 and the total amount of debt on the property after all of the refinancings is now $900,000.00.
Real Estate Market Values Collapse
Fast forward to 2009. The property value has dropped to $600,000.00. The outstanding debt amount is still $900,000.00. The investor has negative equity of $300,000.00. The market appears likely to go lower and some tenants have moved out so that the investors cash flow has dropped.
Selling Under A Short Sale
The investor decides to sell the property and get out from under the negative cash flow. They are able to sell for $600,000.00 and the lender agrees to a short sale. The investor lets out a "Whew!" and moves on with their life. They visit with their tax advisor in April to complete their tax return, and what a surprise they have waiting for them.
They may not have equity in the property, but they do have a gain. Remember, they sold for $600,000.00, and even though the debt was $900,000.00 so that they have not equity they only paid $100,000.00 for the property. They actually have a $500,000.00 taxable capital gain on the short sale. It is so important that investors meet with their tax advisors BEFORE completing any sale, disposition, purchase or 1031 exchange of property to ensure they know exactly what the outcome will be.
The Zero Equity 1031 ExchangeTM
They have probably made their financial situation much worse in this case because they now owe quite a bit in capital gain taxes. They may not have had any other options, but knowing what to expect and evaluating potential options would have been a smart thing to do.
The Zero Equity 1031 ExchangeTM is one of those options. It will not work for everyone, and takes some creative thinking and planning to get it done, but it would allow the investor in this case to sell the problem asset, reinvest in replacement property (hopefully in a slightly better position) and defer the payment of capital gain taxes.