Can a seller add his own money to property sale money to avoid short sale?

Question

Forgive me if this has been asked before - Can a seller add his own money to the money made at sale of a property to pay off a mortgage balance? Say the balance is 43k and I buy the house for 38k - can't the seller just add 5k of his own money to cover the mortgage payoff and avoid short sale?

Jon Holdman · Answer

Hopefully, we have Matt Liu's question answered.

This can happen in several ways.

Consider a residence.  Depreciation doesn't come into play.  Say you bought it for $150K with 20% down.  You have a $120K loan (I'm rounding on all of this).  10 years later its worth $250K, so you do a cash out refi into a new $200K loan.  Your existing loan is about $100K.  That gets paid off and you now have $100K in cash.  Now, I've heard people say "wow, you get that money tax free."  Not true.  Its just that the tax isn't due when you take the loan.  Now, five years later, the value has dropped to $175K.  You still owe $185K.  You sell for $175K and pay costs of $15K, leaving you $160K on the sale.  You kick in $25K to make up the shortage.  All done?  Not quite.  The loan is irrelevant for gains.  You bought for $150K.  You sold for $175K.  You had costs of $15K, so your net selling price was $160.  That's a $10K taxable gain.  Now, if this was your personal residence, you can use the exclusion to avoid that tax, but you still have a taxable gain even though you "lost" $25K.  You didn't really even lose it since you took $100K out of the house.  You just had to pay back $25K out of that $100K you took five years earlier.

Like Bill Gulley says, there are taxes on forgiven debt.  If you did a short sale instead of making up the difference, you would have $25K of forgiven debt in addition to the $10K gain.   This is where the poppycock of "tax free money" from mortgaging your property falls apart.  The taxes are still there, they're just not due until you sell.

A rental is even worse, because of depreciation.  Tax on unrecaptured depreciation is one of the area where I think promotors of rentals really fall down.  The hype the benefits of using passive losses to offset ordinary income (even though the limitations on doing that often kick in), but neglect to mention you're increasing your tax liability when you sell.  Depreciation (even if you don't take it) decreases your basis, increasing the gain when you sell!  Had that example above been a rental, you would have taken about $45K in depreciation.  Your basis is now $105K instead of $150K.  Now your taxable gain is $55K.  Even though you have a "loss" of $25K on the sale (only a loss when you conveniently forget abou the $100K you took out five years earlier), you have a significant tax bill.  Not to mention the tax on unrecaptured depreciation is 25%, not the 15% rate for long term capital gains.  So, you're looking at a tax bill of $12,750 in addition to the $25K you had to kick in to avoid the short.  Again, though, with the $100K you took earlier, you're still ahead by $62,250.  So no whining about the shortage and tax bill at the end.

Jon Holdman · Answer

Bryan A. it seems to be a common misconception that the amount of cash left after paying off the mortgage is somehow related to the taxable gain on the sale of a house.  Its not.  Loans are (mostly) irrelevant to the gains from the sale.  People end up in this position when they HELOC or refi the cash out of their house, then are underwater when they sell.  But they're not selling at a loss.  If they were, there would be no tax.  They've just already taken the gains and now they have to pay the taxes.  Oops!  They've already spent the money they would have used to pay the taxes.

Jon Holdman · Answer

It might require more than $5K in order to cover the costs, but, certainly, the seller can just pay the shortage.

Account Closed · Answer

Jon, the CPA that explained it to us in a meeting mentioned either 1031ing for a while, and then selling this particular property at a loss, but still owing lots of taxes from deals past.  Or, having depreciated a property so much, and upon sale, having to recapture that depreciation.  Big surprise for some people he said!

Account Closed · Answer

Jon's right.  They can pay the difference at closing, but there will be closing costs, maybe agent commissions if they or you are represented.  A CPA just detailed an example for me of how people may sell their house for a loss, yet still owe taxes on the sale as well.  How bout them apples??

Matt Liu · Answer

Thank you for the help. But there is a twist....
I am buying two properties from this seller. On one (the one I mentioned) he will be short 5k on the payoff. On the second house (70k) he will have 5k MORE than the payoff. 
The reason we don't just adjust the prices to be exactly the payoff amount on each house is...

1) I am planning to assign the first house and want it to look cheaper so I can find a buyer (and charge him 5k for the assign) 
 
2) I want the house I keep to be higher on paper so my mortgage is a higher LTV. Yes I pay 5k more on paper, but I get back from the assign.
Also it will be better for resale.

I know it's a bit complicated :)

Bill Gulley · Answer

I don't know, but it might be worse in PA with transfer taxes being based on FMV as seen by the taxing authority as well.

Steven Hamilton II · Answer

Jon Holdman,

Well said.

Bill Gulley · Answer

Forgiveness of debt???  :)

Can a seller add his own money to property sale money to avoid short sale?

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