Calculating the Taxable Gain on a House Sale
Q: I am not sure I understand how to calculate the taxable gain on the sale of my house.
I bought the house for $300,000 and expect to sell it for $1 million or more. I want to buy a replacement that costs $500,000 or so, and am entitled to use the $125,000 profit exclusion allowed home owners aged 55 or more.
The way I figure it, I should deduct the $300,000 original cost basis from the $1 million sales price; then I should deduct the $500,000 repurchase price, then the $125,000 exclusion. By my math--$1 million minus $300,000, minus $500,000, minus $125,000--I should have a taxable gain of $75,000. Right? --N.T.
A: Wrong. Your taxable gain is $375,000. Let’s explain why.
First of all, we have to assume that the $300,000 purchase price of your current house is really the taxable basis of your home. For the purposes of this calculation we will make that assumption, although I suspect that your actual residential real estate basis is quite a bit lower. (Remember, every time you sell a home and trade up, you defer taxation on your gains. Given your age, we can assume that you purchased your first home a few decades ago when home prices were far lower than $300,000. If this is the case, you must plug in your real tax basis into whatever final tax computation you make.)
However, for the sake of an example, let’s use the $300,000 figure you offer. The Internal Revenue Service allows you to deduct from the $1 million sales price only the greater of the taxable basis or the purchase price of the new home. You may not deduct both.
In your case, you would deduct the $500,000 repurchase price from the $1 million and then deduct the $125,000 profit exclusion allowed taxpayers over age 55 from the remaining $500,000. This leaves you with a taxable gain of $375,000.
Why LBO Deals Have Earned Bad Reputation
Q: With all the news these days about how bad leveraged buyouts are turning out to be for the economy and workers, I need to know exactly what these horrible things are. Can you explain them in plain, simple terms and tell why they are souring so? --C.W.
A: In its most simple form, a leveraged buyout--or LBO in trade jargon--is a purchase where the value of what is being bought is used as collateral for the loan the buyer gets to make the purchase. Your home purchase was probably a perfect example of an LBO. In the standard real estate deal, the value of the property being bought is pledged as collateral for the real estate loan. If the buyer defaults, the lender gets the property, as well as the buyer’s down payment.
If you’ve been in the real estate market for more than a decade, you probably understand how an LBO can work to a buyer’s advantage. Buyers making the minimum down payment from their own pocket and financing the rest can reap huge profits on that initial investment when the real estate appreciates.
Let’s say you bought a house for $100,000 10 years ago. You might have made a 20% down payment, or $20,000. That house might be worth $500,000 today, meaning that your $20,000 investment generated a profit of $400,000--a whopping return of 2,000%!
The less you put down on a deal, the greater your leverage. If you had made only a $10,000 down payment on that house, your profit of $400,000 would have represented a return of 4,000%. Of course, you might have been up to your eyeballs in debt with your mortgage, but the lender believed that you could make the monthly payments from your income.
You might think that the above example is just the way real estate works in California, and a part of your birthright. Well, it’s not. And savvy business people have realized that they can apply the same principles of leverage to the commercial market as well. They simply buy businesses by pledging the value of the venture as collateral for the loan and promising to repay the lender from the proceeds generated by the business.
Much like a California home buyer of decades ago, they are betting that the value of the business will appreciate significantly during their ownership--or has been so undervalued to begin with--and thus will be able to sell the venture within a few years at a huge multiple of their original investment.
This can work very well when the debts taken on by the buyer are in sync with the business’s ability to generate income. But when buyers take on billions of dollars in debt, the chances grow slimmer that they will be able to cover their bets by meeting the interest payments.
And when a recession hits and sales sag, the businesses find their debts overwhelming. That’s when they are forced to file for bankruptcy protection, as we have seen in the case of R. H. Macy & Co. and a host of other companies in the last few years.
One of the reasons LBOs and their sponsors on Wall Street and in corporate America are in such disrespect these days is that, by and large, they are not required to pay for their miscalculations and greedy over-leveraging. Their lenders and suppliers, who are out millions of dollars in payments, and in many cases their employees, who are laid off in cost-cutting efforts, bear the brunt of a failed LBO. The buyer may lose his initial stake in the company, but he’s probably not reduced to poverty.
And the Wall Street investment banking outfits that put the deals together are mostly in fine shape. They got their money up front when the deals were struck, not when they went sour.
