Tax savings lured into overpriced appartents

by Johannes Fiala and Klaus Wehrt, lawyers
Many investors succumb to the lure of tax savings. 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%, no equity was required. Thus – not without pride – even those could count themselves among the circle of taxpayers who were cheating the state by paying hardly any taxes.
One-bedroom apartments (approx. 30 m�) in large residential complexes were sold. The total expenditure, for example, amounted to 150,000 DM. This was a lot of money, but the investor did not notice any of this because he financed the property entirely through credit (in 1991, for example, at 10% effective). Instead, his attention was drawn to the immense tax advantages, which were consistently calculated with marginal tax rates of 45-55% (including solidarity surcharge and church tax), i.e. orders of magnitude of which the investor could generally only dream.
Under the old tax law, a high tax saving could be achieved in the first year through a 10% discount. If the purchase price was neglected in the calculation – it was financed by credit – there was already a substantial surplus at the beginning of the commitment.
Despite the discount, in the years of letting the allegedly local rental income of DM 20/m� – DM 600 for 30 m� of living space – was offset by the still higher interest payments of DM 1,040 (nominally 7.5% on DM 166,666), the redemption payments or the capital life insurance premiums were simply misappropriated. 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. From this alone – assuming a marginal tax rate of 55% – a tax advantage of DM 3,575 could be obtained. In addition, according to § 7 para. 5 Income Tax Act for the first three years after completion, a 7% depreciation on the production costs of approx. 130,000 DM applies – tax saving: 130,000 DM * 0.07 * 0.55 = 5,005 DM. 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.
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. At the latest from the 10th year onwards, in which only a depreciation rate of 2% 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 of 166,666 DM – the continuous repayments of the investors are thereby excluded, because also the initiators underestimated them in their model calculation.
It is unlikely that anyone could achieve such a high price by selling a 30 m� condominium. Even in the event that the net cold rents, which are usually exaggerated by the initiators, actually materialise, the capitalised value of the above-mentioned property amounts to just DM 100,000. If the actually achievable rents of approx. 15 DM/m� are taken into account, this results in an income value of only approx. 75,000 DM. The property market report of the city of Kaiserslautern from 1996 therefore notes that the inexperienced out-of-town owners have to expect large discounts compared to the purchase price.
Investors are disappointed. Only the initiators deserve this. However, the situation is not as hopeless as it may first appear. 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.
Many parties generally made money on the sale of the overpriced condo. 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. Often, however, the defrauded investors surrender to their fate. And legal practice also pays too little attention to the fact that the existing law gives those affected sufficient opportunities to rectify the situation without having to pay a fine.
The easiest way is to have the purchase contract subsequently qualified as invalid by proving to the seller the immorality of the concluded purchase contract. The consequence is that the seller gets the apartment back, in return he has to refund the purchase price.
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%. 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. The expert shall survey the net cold rent customary in the locality for comparable properties. Adjusted for the regular costs of management and maintenance, he will then calculate a projected annual income, which he will extrapolate over the useful life of the property. Discounted to the present, the result is the income value of the property, which indicates the maximum purchase price that could have been paid to make the property profitable from the point of view of the capital investment under which it was acquired.
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. 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 – is always expected to act in an advertising capacity, no misleading or untruthful information may be provided.
The duties to inform and advise are even approximated to those of an investment advisor if the intermediary has 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. As a rule, the bank granting the loan remains the final addressee for claims for damages. According to established case law, she is guilty of contributory negligence in particular when she:
(a) went beyond its role as a mere lender in connection with the planning, implementation and marketing of the real estate project,
(b) by granting the loan, it created an additional risk for the buyer that went beyond the general economic risks of the project,
(c) engaged in serious conflicts of interest by granting loans to both buyers and sellers,
(d) had specific knowledge of the economics 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
PhD, MBA, MM

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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