A theme I keep running into lately is potential clients who have a home that is their principal residence plus a piece of rental property. It seems there are a lot of misconceptions about the consequences of owning rental property. Thus, 5 myths about rental property and bankruptcy…
Myth #1: If I have rental property that is operating at a monthly loss, I am stuck with it until it has equity.
This could not be further from the truth. But, there are bad ways to dispose of properties and better ways to dispose of properties. For example, say you are nearing retirement and have your own home, plus two small rental properties that do not pay for themselves. Say those properties cost you a net loss (when you calculate mortgage, taxes, insurance, and maintenance expenses) of $300 per month. Of course, this may not seem like much. A few hundred dollars spent per month, but you have property.
Hogwash. Remember I said you are nearing retirement? Why in the world would you spend $300 per month on property that might have a hope and a prayer of having actual equity in about a dozen years when you could be putting that money toward retirement, or in savings, or paying down the mortgage on your own home to eventually eliminate your house payment? Owning those rental properties is just a legal fiction of ownership on paper. You own nothing. In fact, these properties are slowly sucking you dry.
Get rid of it. Stop the bleed.
But, how do you do it? Well, you need to understand how owning a rental property affects you legally. First, remember that if that rental goes to foreclosure, you will likely receive a 1099-C for miscellaneous income on the forgiven debt. What does that mean, exactly? It means the difference between what you owed on the property at foreclosure and the current market value of the property at foreclosure presents a gap. Say the property was only worth $150,000 at foreclosure. You owed $300,000 when they foreclosed. Now, you will have to report to the IRS that you had the difference of $150,000 in income on your taxes. If you are in a tax bracket that results in 14% tax, that’s a tax bill of $21,000, aside from your other income tax.
Yeah. Not so pretty.
Myth #2: I can’t or shouldn’t file bankruptcy to deal with rental property issues.
Wrong. Now, building off the example above, say you file a Chapter 7 bankruptcy before stopping payments on that rental and surrender that property in the bankruptcy.
What many people do not realize is that, a foreclosure in bankruptcy is fundamentally different than a foreclosure after a property is surrendered in bankruptcy. There are absolutely intricacies and nuances that you should speak with an attorney about, but generally speaking, surrendering a rental property in a bankruptcy will yield a better result than just abandoning the property and letting them have it.
The magic number is 1082. That’s a form that your tax person can include with your tax return that, in essence, says, “hey, I know I didn’t pay this debt, but it wasn’t forgiven debt, it was debt that was discharged in a bankruptcy, so I won’t be required to pay taxes on that.”
That’s pretty powerful stuff. In the scenario above, it’s the difference between paying $21,000 to the IRS or not.
Myth #3: So, if I surrender a property in bankruptcy, it can wipe out all my tax obligations related to that property.
Unfortunately, the bankruptcy can’t do everything for you. And it can’t wipe away all tax obligations.
Most people don’t notice what their tax accountant is doing, but if you pull out your previous tax returns, you’ll probably see that your accountant took a depreciation on that rental property each year leading up to you deciding to dump it.
When that house goes, capital gains tax rears its ugly head.
And the bankruptcy can’t fix that for you. Not before the fact or even if you file after (unless the tax is so old that it is dischargeable and no lien has been filed by the IRS, but that’s a whole other blog post). So, capital gains, you are stuck with. Boo.
But it’s still not as bad as a $21,000 tax bill plus capital gains tax to boot.
Myth#4: If I do a short sale, this will help me avoid all these problems with foreclosures and taxes.
I disagree. Of course, you’ll find real estate agents who blatantly practice law without a license by espousing the benefits of a short sale over a foreclosure or a short sale over doing a bankruptcy, but you need to remember two things about this conversation with the real estate agent. 1) they want your listing because they will get a commission off the sale, and 2) they are looking at only one aspect of your financial situation, which leads to a simplistic view of your options.
If you have credit card debt, issues with your own mortgage being overly expensive, tax issues, or even a car payment that is expensive for you, you could take care of a whole myriad of issues with a bankruptcy, whereas a short sale only handles the issue of that one property. It’s kind of like putting ointment on a sore when what you really should do is go to the doctor and get an antibiotic that cures the underlying infection. Sure, the ointment will spot treat, but it doesn’t do as much as the medicine that treats the disease itself.
Consult with an attorney. Most bankruptcy attorneys don’t even charge for a consultation, but even if it costs you $150, it’s money well spent.
Myth #5: If I already let a rental property go to foreclosure, a bankruptcy won’t help me.
This may or may not be true, but I would hazard a guess that 9 times out of ten, it’s false.
The typical scenario I see along these lines is the client who waited until after rental properties foreclosed and does not want to do bankruptcy, so they figure they’ll just keep paying on everything because eventually they will be able to take care of it.
The problem is, if you have a tax debt, you need to address that first (or last, depending on how you look at it.) For example, say you have $40,000 in credit card debt, and now you got your taxes done and are appalled to realize you also have a $20,000 tax debt on a foreclosed rental. You think, well, I’ll just wait to pay the IRS, or pay them $150 a month on an installment agreement while I also pay on the credit card debt. I mean, I borrowed the money so I should pay it.
Yet you also have absolutely no savings, very little or no retirement, and are not currently contributing to a retirement account.
So, let me get this straight… you have no money in case you lose your job, you have no plan for retirement, but you are still paying for that pizza you ordered three years ago, the sheets you bought at Macy’s five years ago and already have holes in them, and a rental property you don’t even own anymore. And the IRS taxes. And interest on all of it. All at the expense of your short-term and long-term future financial security?
I’d say doing the dreaded bankruptcy is not as bad as being in financial ruin for an indefinite period and facing the prospect of living on only $1,000 per month social security if you are later unable to work until you die. Bankruptcy is there for a reason: to give you a fresh start. Let it help you accomplish that if you need it.
As a final note: the IRS recently loosened up their requirements for accepting an offer in compromise on tax debt. While a bankruptcy won’t wipe away the taxes, why not wipe away the debt that can be extinguished, and then deal with the IRS to the best of your ability by seeing if you can get an OIC granted. Some attorneys do tax law, bankruptcy, and modifications. Try to find an attorney that has the skills to do more for you, rather than less.
That would be the ultimate fresh start.