Solving Tax Problems on Real Property Sold Via a Short-Sale, Foreclosure or Deed-In-Lieu of Foreclosure with a Zero Equity 1031 Exchange™
Real estate values dropped significantly during The Great Recession. Significant drops in fair market value can place the real estate investor in a distressed position for many reasons, and may eventually force the investor into a fire sale, short-sale, foreclosure action or deed-in-lieu of foreclosure situation.
Real Estate Investors Often Ignore Tax Consequences
Fire sales, short-sales, foreclosure actions, and deeds-in-lieu of foreclosure increase significantly during recessionary times. Unfortunately, real property owners often focus on the financial aspects and ignore the potential income tax consequences when trying to structure a work out for their distressed property. Real estate investors often incorrectly assume they have no income tax consequences to worry about since they have no (or negative) equity in their property.
Investors may still have a significant taxable gain to be concerned about, so it is absolutely critical that the investor meet with his or her tax advisor to ensure they know exactly what their income tax consequences will be before they proceed with any work out scenario.
The following distressed commercial property scenario will be used throughout this article to help illustrate the potential income tax consequences that must be analyzed before proceeding with any potential strategy.
An investor acquires a commercial office building for $1 million to hold for long-term investment purposes, and begins depreciating the property over 39 years. The property increases in value over the holding period to $3 million. The investor then refinances the property at this time by borrowing $2.4 million from a bank.
We now fast forward to 2009 and the recession has taken its toll on the property. The investor has lost a significant number of tenants — and therefore cash flow — and the property’s fair market value has dropped to $2 million. The investor’s adjusted tax cost basis is now $600,000.
The investor can no longer cover the debt service requirements, so the bank forecloses on the property and acquires the property at the Trustee’s auction.
Alternatively, the investor could have agreed to convey the property to the bank without the hassles and costs of foreclosure by agreeing to execute a deed-in-lieu of foreclosure. The bank may be willing to give the investor some concessions under these circumstances, but it has been my experience that banks will generally not accept the deed-in-lieu of foreclosure because they want to ensure that any possible liens against the property are extinguished through the foreclosure process. However, the deed-in-lieu of foreclosure can be a potential solution under certain circumstances.
Potential Tax Consequences on Disposition of Distressed Property
There are numerous issues that must be analyzed when a property is disposed of, or surrendered, through a short-sale, foreclosure or deed-in-lieu of foreclosure transaction in order to determine the potential income tax consequences that might come into play.
In addition, the IRS has not provided clear guidance, and in some cases no guidance, regarding some of the issues involved with these workout scenarios, so a careful review by the investor’s tax advisor prior to consumating any specific transaction is critical.
Problems: Taxable Gain, No Equity and Mortgage Over Cost Basis
The investor has three (3) problems in the above case study that will most likely generate or indirectly result in significant tax consequences.
The first problem is that the investor has a taxable gain. The property currently has a fair market value of $2 million with an adjusted tax cost basis of $600,000. The question is: what is the sales price of the property when it is sold via foreclosure?
Second, the investor has no equity in the property. The fair market value of the property has dropped well below what the investor owes to the bank. There is a taxable gain, but no equity in the property, since the adjusted tax cost basis is only $600,000.
And, the third and potentially the most problematic, is the fact that the investor’s debt owed to the bank significantly exceeds the fair market value of the property and the adjusted tax cost basis of the property, which is often referred to as mortgage over basis.
Case Study Analysis
Short sales, foreclosures or deeds-in-lieu of foreclosure are all considered to be sales or dispositions of the real property for income tax purposes. The property has in fact been sold in this case study since the bank has acquired the property at the Trustee’s auction.
The "sales price" must therefore be determined in order to know what the income tax consequences will be and what potential solutions might be available since the property has been disposed of through foreclosure. The deemed sales price will depend on whether the debt was recourse or nonrecourse debt to the investor.
The "sales price" will generally be deemed to be $2.4 million in our case study, which is the value of the outstanding debt amount, because the debt is nonrecourse to the investor. There are, of course, variations and exceptions, so be sure to verify this with your tax advisor. The taxable gain would be $2.4 million less the adjusted tax cost basis of $600,000 or $1.8 million. I have ignored closing costs in this case study.
The outcome would be different if the debt were actually recourse or partially recourse to the investor. The deemed "sales price" would be $2 million in our case study, which is the fair market value of the property, if the debt was recourse to the investor.
The $400,000 difference between the $2.4 million outstanding loan balance and the $2 million fair market value is considered debt forgiveness and is taxed differently. The investor would generally have a higher tax liability when they have recourse debt.
Solutions, Strategies and Thoughts
The key here is to devise a 1031 Exchange strategy so that the property lost through a short-sale, foreclosure or deed-in-lieu of foreclosure can be traded into another property thereby eliminating the huge tax liability.
Sadly, most investors are not aware that you can still complete a 1031 Exchange on property sold via a short-sale, foreclosure or deed-in-lieu of foreclosure when there is no equity in the property. And, even more disturbing is the fact that many Qualified Intermediaries actually advise clients that you can not structure a 1031 Exchange when no equity exists.
IRS Issues Private Letter Ruling
The Internal Revenue Service issued Private Letter Ruling 2013-02009 (PLR 201302009), which permits investors to structure 1031 Exchange transactions when they are losing a property through a negotiated deed-in-lieu of foreclosure transaction.
The investor would assign his or her rights pursuant to the transfer agreement with the lender to Exeter 1031 Exchange Services, LLC, as their Qualified Intermediary. The transfer of the relinquished property via a deed-in-lieu of foreclosure would then qualify as an "exchange of property held for productive use in a trade or business or for investment" under Section 1031. This Private Letter Ruling is the first ruling from the Internal Revenue Service to expressly authorize the use of a like-kind exchange transaction for over encumbered property (i.e. property with negative equity).
Zero Equity 1031 Exchanges™
Investors can use the Zero Equity 1031 Exchange™ to defer their taxable gain when selling property via a short-sale, foreclosure or deed-in-lieu of foreclosure. Zero Equity 1031 Exchanges™ are completed all the time, even in good real estate markets, and can be an incredible solution for the investor when selling property with no equity or negative equity. However, Zero Equity 1031 Exchange™ transactions can create practical issues that must be addressed.
The structure is identical to any other regular 1031 Exchange transaction. The investor still needs a Qualified Intermediary. The Qualified Intermediary must still be assigned into the Sales Agreement and any escrow instructions.
The only difference between a Zero Equity 1031 Exchange™ and a regular 1031 Exchange is that there is no equity in the property, so no cash (net proceeds) would be sent to the Qualified Intermediary upon the close of the relinquished property.
The challenge is how to acquire like-kind replacement property when there is no equity remaining in the relinquished property. The relinquished property is essentially 100% debt at this point in time, so the acquisition will most likely need to be 100% debt (or close to it) since the investor probably has no out-of-pocket cash to add to the purchase. It takes lots of creativity to make the Zero Equity 1031 Exchange™ work.
Seller Carry Back Notes
One solution would be to locate replacement property where the seller is motivated to cooperate by carrying back paper. This gives the investor the most flexibility in terms of putting an acquisition together with potentially little to no cash down.
Zero Coupon Replacement Property
Absolute triple net leased replacement properties with national credit tenants can be structured as zero coupon transactions. Debt can often be put in place at 95% LTV even in today’s market so that the investor does not have to come out-of-pocket with much, if any, cash.
This investment vehicle produces no monthly cash flow, but may allow the investor to structure a Zero Equity 1031 Exchange™ and defer their taxable gain until they find a better solution or the real estate market recovers.
Trading Down in Value
Investors that have difficulty in servicing their debt load may wish to consider structuring a partial 1031 Exchange. Structuring a partial 1031 Exchange by trading down in value may assist the investor in restructuring his or her current portfolio to ease his or her current debt servicing requirements.
Zero Equity 1031 Exchange™ Structural Concerns
1031 Exchanges require that the Qualified Intermediary "acquire" the relinquished property from the investor and then convey the property to the buyer. Subsequently the Qualified Intermediary acquires the replacement property from the seller and conveys it to the investor to properly structure the transaction and qualify for 1031 Exchange treatment.
Prior to 1990 this was accomplished by the Qualified Intermediary by acquiring legal title to the relinquished property from the investor in every 1031 Exchange, subsequently deeding the property to the buyer. This was referred to as sequential deeding. This practice was eliminated with Revenue Ruling 90-34, which permits "direct deeding" so that the Qualified Intermediary no longer acquires legal title to the property (except for reverse and build-to-suit 1031 Exchanges).
Short-sale 1031 Exchanges are easy to structure. There is always a Sales Agreement, and the Qualified Intermediary will assign into the sales contract, and complete the 1031 Exchange like any other 1031 Exchange.
However, foreclosures are a completely different issue. There is no Sales Agreement. The property is being foreclosed upon or taken from the investor. There is no contractual relationship to be assigned to the Qualified Intermediary.
So, we must generally revert back to the old ways of sequential deeding where legal title to the relinquished property is once gain acquired by the Qualified Intermediary and then subsequently conveyed by deed to the buyer.
This should eliminate the risk of a disallowed 1031 Exchange since the Qualified Intermediary has literally acquired title to the property, but the investor should be aware that there is no guidance specifically on this issue.
Deed-In-Lieu of Foreclosure
Alternatively, the investor could approach the lender and offer to convey the property via a Deed-In-Lieu of Foreclosure. An agreement is generally drafted in cases such as this, and the Qualified Intermediary can assign into the agreement and complete the 1031 Exchange.
However, lenders often refuse to consider a Deed-In-Lieu of Foreclosure due to concerns over liens against the property, so this may not be an alternative for the investor.
Exeter 1031 Exchange Services, LLC
The 1031 Exchange Advisors at Exeter 1031 Exchange Services, LLC are always available to assist you and/or your clients in the planning, structuring and implementation of 1031 Exchanges.
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