Investors can defend themselves!

by Klaus Werth and RA Johannes Fiala
Many investors succumb to the lure of tax savings. But if the property only brings losses in the long run, then only the initiators have earned from it. But the investor can recover money through legal action in certain cases. Whereas in the past it was the well-paid medical profession that plunged into property developer models, the group of aggrieved capital investors has changed considerably in recent years. The victims of tax-saving schemes increasingly include groups of people who have neither large assets nor incomes burdened by high marginal tax rates. The purchase of condominiums was offered. Because the financing was to be 100 percent, no equity was required. Thus ? not without pride ? also belong to the circle of taxpayers who cheat the state by paying hardly any taxes. Small apartments for DM 150,000 One-room apartments (approx. 30 square metres) in large housing estates were sold. The total expenditure, for example, amounted to DM 150,000. This was a lot of money, but the investor did not notice any of this because he financed the property entirely through credit. Instead, his attention was drawn to the immense tax benefits, which were consistently calculated with marginal tax rates of 45 to 55 percent (including solidarity surcharge and church tax), but which many investors did not even reach. According to the old tax law, in the year of completion, in addition to the favourable depreciation according to § 7, para. 5 EStG, a high tax saving could be achieved by means of a ten per cent disagio (a loan of DEM 166,666 was taken out for a disbursement of DEM 150,000). Did they neglect the purchase price in the calculation ? that was financed by credit ? so there was already a healthy surplus at the beginning of the engagement. Despite the disagio, in the following years the allegedly local rental income of 20 DM per square metre ? 600 DM for 30 square meters of living space ? the still higher interest payments of DM 1,040 (at a nominal 7.5% to DM 166,666); the redemption payments or the capital life insurance premiums were simply ignored. But even this shortfall of 440 DM should not hurt, because an old wisdom says that tax advantages are only obtained by those who make losses. The deficit on an annual basis thus amounted to approx. 5,300 DM, including administration costs and maintenance allowance even to approx. 6,500 DM. Already from this ? Marginal tax rate of 55 percent assumed ? a tax advantage of DM 3,575 can be drawn. In addition, according to § 7, para. 5 of the German Income Tax Act apply for the first three years after completion a seven-percent depreciation on the construction costs of approx. 130,000 DM? Tax savings: 130,000 x 0.07 x 0.55 = DM 5,005. Instead of a shortfall, a surplus: The annual deficit of 6,500 DM was to be compensated by notified tax benefits of 8,580 DM. The math doesn’t add up So far, so good. The initiators did not say a word about the future years in which the advantages of the high depreciation rates would gradually disappear. From the tenth year at the latest, in which only a depreciation rate of 2 percent applies, the calculation will no longer add up. The early sale of the property is not an alternative. A net profit can book namely only that, which obtains a purchase price, which exceeds the owed remainder capital (166,666 DM ? the repayments of the investors are still excluded thereby, because also the initiators ignored them in their model calculation). Investors are disappointed Such a high price can hardly be achieved by selling a 30 square meter condominium. Even in the event that the net cold rents, which are usually exaggerated by the initiators, actually materialise, the capitalised value of the property is just DM 100,000. If one takes into account the actually attainable rents of approx. 15 DM per square metre, this results in an income value of only approx. 75,000 DM. Investors are disappointed. Only the initiators deserve this. However, the situation is not as hopeless as it may seem at first. Owners who take legal action have a chance of getting off lightly. Starting points are a possible immorality of the original purchase contract, but also a consulting fault at the conclusion of the contract. Defrauded investors can defend themselves In the sale of the overpriced condominium, many parties have generally earned. The property development company created the property, the financial intermediary recruited the buyers, the credit institution provided the required loan funds, the trustee signed the property purchase agreement on behalf of the buyer, and the notary public notarized this agreement. In principle, action can be taken against any of these parties if they have culpably breached a duty. There are certainly options that the law gives to those affected. The easiest way is to have the purchase contract subsequently qualified as invalid by proving the immorality of the purchase contract to the seller. The consequence is that the seller gets the apartment back, in return he has to refund the purchase price. Expert opinions are required According to the current case law, the limit of immorality in the purchase of real estate may already be reached if the purchase price exceeds the justified price by more than 80 percent. In order to determine the degree of discrepancy between the justified and the actual purchase price paid, it is usually necessary to obtain an expert opinion on the income value of the property. This value indicates the maximum purchase price that could have been paid to make the property profitable from an investment point of view. In most cases, the immorality of the purchase contract is compounded by further culpable breaches of duty on the part of the seller or his representatives. In this way, the seller is also liable for damages to the buyer. One starting point for this is prospectus liability. A sales prospectus must satisfy three conditions: completeness, accuracy and absence of misleading information. Where appropriate, there is a duty to rectify. Liability issues However, the seller is also liable for breaches of duty by investment intermediaries, whom he usually uses to sell the property. Although the investment intermediary ? in contrast to the investment adviser, who generally works for the prospective investor on a fee basis ? The customer is always expected to behave in a promotional manner, but no misleading or untruthful information may be provided. Duties of the investment intermediary The duties of clarification and advice are even approximated to those of an investment adviser if the intermediary placed a special trust in the investor. Even a personal acquaintance can justify this protection of legitimate expectations: Club mate, work colleague. the same applies if the intermediary acted on a recommendation. It is not uncommon for the real estate buyer to fail in enforcing his claims because the sales or brokerage organization has already been dissolved. He then faces the problem of looking for other responsible parties against whom he can enforce his claims. The bank granting the loan remains the final addressee for claims for damages. According to established case-law, it is guilty of complicity in particular where: – it has gone beyond its role as a mere lender in connection with the planning, implementation and marketing of the real-estate project  by granting the loan, it created an additional risk for the buyer which went beyond the general economic risks of the project – it placed itself in a situation of serious conflict of interest by granting loans to both the buyer and the seller – it had specific knowledge advantages with regard to the economic viability of the project which it did not pass on to the buyer. The bottom line is that there is a good chance of ending the loss-making engagement with a black eye.

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About the author

Dr. Johannes Fiala Dr. Johannes Fiala

Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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