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I’ve recently met with several prospective duplex home sellers who, facing a slower real estate market, were surprised to find the IRS could save the day.
In each case, the property owners had owner-occupied their duplexes at some point in the last five years, ultimately moving out and renting their old unit.
Of course, one of the benefits of owner occupying a duplex is the ability to avoid any capital gains tax on the unit that wasn’t leased; provided the owner lived in the premises two of the last five years.
While I encouraged all of these sellers to consult a qualified tax professional, most reported back by selling now and avoiding capital tax on their half of the duplex, they would be saving thousands of dollars.
This was a bit of a silver lining for them, as it was as if they’d found some of the money they thought they’d lost; in the sofa.
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Do you always have to pay depreciation recapture and capital gains tax when you sell your duplex via a short sale or lose it to foreclosure?
I spoke with three accountants last week and the answer, as always, is circumstance dependent.
If a duplex home owner can prove insolvency, the tax obligations may be avoided.
What’s insolvency?
Basically, it’s when all of your assets don’t outweigh all of your liabilities. With a home mortgage, a duplex mortgage and credit card debt, for many that may be easy to prove.
However, as explained to me, you have to be able to prove you were not only insolvent before you sold or lost the duplex investment, but after as well.
For example, if you have a $100,000 in equity in your home, with a $50,000 mortgage, and no equity in your duplex that has a $200,000 mortgage on it, you owe $250,000 and only have $100,000 in assets. Therefore, you’re insolvent.
But, after you sell the duplex via short sale or lose it in foreclosure, you now have $100,000 in equity in your home and owe $50,000 on the note. In other words, you’re worth $50,000 more than you owe.
As always, be sure to speak with your tax chick for specific advice.
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The name of this blog is Duplex Chick.
Not Accountant Chick.
To that end, please heed the following disclaimer: if you’re a duplex home owner facing a short sale or foreclosure, please consult with an accounting chick when you’re considering your course of action.
Don’t worry. She’ll be in a good mood. She’s going to have plenty of business.
See, even though Minnesota is a non-recourse loan state, meaning the mortgage is collateralized by the property; the bank can’t come after you for the amount of the loan you’re forgiven through a short sale or that’s lost on a foreclosure.
However, if you’re an investor, the IRS may perceive that forgiveness as a “capital gain”, and therefore might pursue you for capital gains tax. Oh, and remember how you depreciated the heck out of the place on your taxes? Depreciation recapture tax still exists; even if you didn’t sell the property for a profit.
On the other hand, if you lived in the duplex, the Mortgage Debt Relief Act of 2007 allows you to exclude up to $250,000 of gain if the property was your principal residence for at least two of the last five years. Whether or not this exception applies to the half you didn’t live in is a question for that accountant.
But just like the investor, you depreciated the heck out of the side you didn’t live in too, right? After all, that’s one of the many advantages of duplex ownership.
Guess what. Depreciation recapture probably applies to you too.
Depressing, yes. But remember, insofar as the capital gains tax, it pertains only to the amount of debt you were forgiven. So if you owed $150,000 and sold the duplex house for $100,000, you’d be taxed on the $50,000 you didn’t pay.
However, if you lost the duplex to foreclosure, you’d be taxed on the entire $150,000.
