REAL ESTATE investors are born optimists.
You know, the kind of person who looks at an office building and envisions 99 percent occupancy and cash flow measured in many thousands of dollars, while you're wondering why anyone would occupy such a dilapidated, out-of-the-way structure.
Investors in brick and mortar also like to make money. So chances are, when investigating another investment, Mr. Optimist sees dollar signs -- not what happens if the market goes south, tenants vacate and that gushing cash flow dries to a drip.
A rosy outlook is nice, but given today's economic times, it helps if an investor plays devil's advocate, looking at every investment with a jaundiced eye. To say: "What if?"
John Reed, a California-based real estate writer for more than a decade, has put together what he calls an "If I lose control" balance sheet. More common sense than radically new ideas, the balance sheet forces an investor to look at what happens to the thousands of dollars in equity many owners count on as a damage-control cushion should he or she run into serious financial difficulties.
"The 'If I lose control' balance sheet is very different than the normal balance sheet a real estate investor puts together," Reed said. "It reveals how quickly equity is consumed if the investors falls behind in payments."
Once the investor loses control, large additional expenses, including foreclosure attorney's fees and in some cases even loan prepayment penalties, must be added to mortgage balances.
Investors also are subject to what Reed calls phantom gains -- gains on which state and federal income taxes must be paid.
"Investors almost never give any thought to the tax consequences in a foreclosure situation," said Garry Graber, partner in charge of the bankruptcy practice in the Buffalo office of the law firm Hodgson Russ Andrews Woods & Goodyear. "I see situations all the time where taxes are owed and the investor has no proceeds to pay them."
The situation resembles that of residential home buyers who sell one residence but do not purchase another home of equal or greater value within two years. It can be a rude introduction to capital gains.
For investors, foreclosure or giving a property back to the lender is considered a sale for tax purposes. The auction bid or loan amount is the tax sale price and the gain is the difference between the sale price and the investor's original cost less cumulative depreciation claimed. In many cases an investor is liable for thousands of dollars in taxes on a property in which every invested dollar was lost.
"You might depreciate a property down so far that when the property is foreclosed on, the difference between the amount the lender (or another bidder) bids and the depreciated value is considered taxable," said Graber. "The amount bid at foreclosure is considered the amount the owner received because he is relieved of his liability."
For example, you have a $300,000 mortgage and have depreciated the loan down to $200,000, but the mortgage amount owed is still $250,000. At a foreclosure, the depreciated amount is subtracted from what is still owed and the difference, $50,000, is taxable.
Should an owner default and the lender foreclose, there's no escaping the tax liabilities inherent with any sale. Don't rely on declaring bankruptcy. Income taxes, along with such things as alimony and child support, are some of those little extras not discharged, or wiped out, by filing for bankruptcy protection.
Theoretically, there also is another legal potential for loss. "You're also personally liable in the foreclosure," said Roger Ross, a partner with the Buffalo office of the law firm Hurwitz & Fine. "The bank can sue you, the individual, for the deficiency between what's owed on the property and what they can get for it. It's not often done, but given today's banking situation, it may become more common."
In New York, a bankrupt individual can keep $10,000 of equity in his house, $20,000 per couple, along with $2,400 in a vehicle, Reed said.
What's the solution? Sell a property in an orderly, voluntary, non-foreclosure fashion, Reed said. Hurwitz & Fine's Ross said real estate investors should take steps to work with the lender to avoid being mired in foreclosure and its attendant unpleasantries.
"The first thing that an owner should do is talk with his lender," Ross said. "Most lenders don't want another piece of real estate. They sometimes will allow you to ride out slow periods, extend the term of the loan or allow you to make a partial payment, perhaps even miss a payment. But you have to communicate your situation to them."