Husband and Wife are going through a divorce, and own multiple rental properties. Wife hires our office to assist her in understanding the financial implications of her agreements. Her attorney lets her know she doesn’t need our help; the calculation is simple. Each of their equity in the properties is worth:
Fair market value minus loans divided by 2
While this is the simple way of calculating a home’s value, we are drastically underestimating the complexity of valuing a rental property. What is being failed to consider is:
1. Taxes. Rental properties are unique, in that you typically depreciate them over time. While most people see this as a simple tax deduction, unless you use a 1031 exchange or similar mechanism to roll the money from one home to the next, you will have your depreciation “recaptured” and owe taxes accordingly. In addition, you have capital gains taxes on the sale of the property, that are not limited like with your own personal home. Other additional taxes, such as Net Investment Income Tax (NIIT) may also apply. These are all deductions against the true value of the property if you sold it. For each property, in this instance, after taxes the properties were each worth between $40,000 - $60,000 less than originally valued.
2. Closing Costs. The only way you are getting the true value out of a home is by selling it, and selling it typically requires closing costs. Closing costs could be up to 7% of the sale price, which seems minor until you look at example. For instance, on a $850,000 house, closing costs could be up to $59,500. This is another big negative in regard to the true value of a home, amongst other items like maintenance and necessary repairs. For instance, does the home need a new roof? Or have issues with termites?
Without consideration for multiple other items we needed to resolve in the proposal for our client, just reviewing the true value of the properties alone allowed her to better understand the financial implications of keeping or receiving a buyout for the homes, but also helped her feel more secure in her decision-making process.
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