Foreclosures of commercial and multi-family property are expected to increase in 2010, due primarily to the decline in real estate values, high vacancy rates, and the unavailability of commercial loans. In some situations, a foreclosure can result in taxable gain to the property owner despite the lack of economic gain. This article examines how a property owner can use a Section 1031 exchange to defer the payment of taxes on this "phantom" gain.
Tax Consequences of a Foreclosure.
A foreclosure, or a deed in lieu of foreclosure, is a disposition of the property for income tax purposes, and thus, the property owner will have tax consequences. This is true even though the property owner receives no cash from the transfer of the property to the lender. The tax consequences usually do not present a problem because the property owner will have a taxable loss from the foreclosure. In other words, the adjusted tax basis in the property exceeds the amount of the debt. (Adjusted tax basis is generally the purchase price of the property, plus capital improvements, less depreciation deductions).
While many foreclosures result in tax losses, some will produce a taxable gain. Taxable gain occurs when the mortgage amount or debt relief exceeds the property’s adjusted tax basis. This can happen when the property owner acquired the property in a prior Section 1031 exchange, with the property’s adjusted tax basis reduced by the gain deferred in the prior exchange. It can also happen when the property owner pulled tax free cash out of the property in a refinancing, or took depreciation deductions in excess of the equity investment in the property.
When there is taxable gain in a foreclosure, the property owner unfortunately will have no equity in the property to pay the tax on the gain. The good news is that this gain can be deferred through a Section 1031 exchange into another like-kind property. The bad news is that many property owners going through a foreclosure will not have the financial means or the courage to acquire more property.
Computation of Gain upon Foreclosure.
The computation of gain upon foreclosure depends on whether the debt is recourse (i.e. the owner has personal liability and the owner’s other assets may be used to satisfy the debt), or non recourse (i.e. the owner does not have personal liability for the debt and the lender’s only recourse is to take the property).
If the debt secured by the property is nonrecourse, the property owner will have taxable gain from the foreclosure to the extent that the adjusted tax basis of the property is less than the outstanding principal amount of the debt being satisfied by the foreclosure. For example, if the nonrecourse debt is $5 million, and the adjusted tax basis in the property is $2 million, the property owner will have $3 million of taxable gain from the foreclosure. The taxable amount will equal the principal amount of the debt, even if the property is “under water” and the fair market value of the property is lower than the principal amount. The property owner will owe tax on this gain for the year in which the foreclosure occurs, unless the tax can be deferred in an exchange.
For recourse debt, the taxable gain from the foreclosure is limited to the fair market value of the property at the time of the foreclosure. Any taxable income from debt relief in excess of the fair market value is cancellation of indebtedness income (“
Deferring Foreclosure Gain through an Exchange.
In a “normal” tax deferred exchange of encumbered property, the sale of relinquished property will typically result in some cash proceeds as well as some debt relief. In a foreclosure sale, debt relief is the only consideration received by the property owner. Nevertheless, Section 1031 should apply to a foreclosure just as it does to a “normal” disposition of property (although there are no specific rulings on this issue). The property owner has essentially sold the property to the lender for the amount of the debt as consideration (other than any portion treated as COD). Under the rules of Section 1031, the property owner receives consideration in the form a debt assumption, which can be offset with debt assumption on the replacement property. Alternatively, if the property owner does not want to assume new debt in the amount of the relinquished property debt, the regulations under Section 1031 make it clear that the property owner may offset the relinquished property debt relief with an investment of non-exchange cash in the replacement property.
What does this mean in terms of the exchange requirements? The property owner will need to acquire replacement property at least equal to the amount of the debt relief gain from the foreclosure. Because new cash or cash “boot” also offsets liability relief, the property owner may replace some or all of the debt with equity. In the above example with non recourse debt, the property owner would need to acquire a replacement property valued at least at $5 million to offset the debt relief of $5 million from the relinquished property. The property owner could acquire this replacement property with new debt of $5 million, equity of $5 million, or any combination of debt or equity. The normal 1031 time limitations would apply (i.e., the property owner would have 45 days from the date of the foreclosure to identify the replacement property and 180 days from the date of the foreclosure to acquire the replacement property).
Structuring an Exchange.
The regulations to Section 1031 allow a property owner selling property in a cash sale to structure the sale as an exchange, with minimal involvement of the buyer, by using a “qualified intermediary” or “QI” as a middleman. The QI also can be used when the relinquished property is being transferred to a lender through foreclosure (or deed in lieu of foreclosure). However, the exchange may be a bit more difficult to structure. There are two possible methods.
Assignment of Deed in Lieu Agreement. The first method is the “assignment” method in which the property owner’s rights under the transfer agreement with the transferee are assigned to the QI and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of property. The QI does not take actual legal title to either the relinquished property or the replacement property. The assignment method is used in almost all “normal” deferred exchange transactions because it involves the least amount of cost and disruption to the actual sale of the property to the buyer. The property owner’s rights in the sale agreement are simply assigned to the QI at closing and the buyer receives a written notice of this assignment. The assignment method could be used if the property owner has a written agreement with the lender for a deed in lieu of foreclosure for the relinquished property. In a foreclosure, however, there typically is no written sale agreement between the property owner and the lender to assign to the QI, so the exchange must be structured using the other method.
Transfer of Relinquished Property to QI.
Under the other possible method of structuring the exchange, the QI acquires legal title to the relinquished property immediately prior to the foreclosure. This transfer can increase the cost of an exchange because of the additional deed recording fees or real property transfer taxes. Often, however, the property is owned in a special purpose entity, and this entity is also a disregarded entity for federal tax purposes, such as a single member LLC. A transfer of the LLC interest is considered a transfer of the relinquished property in the exchange. Thus, the property owner can assign the membership interest in the LLC to the QI, effective immediately prior to the foreclosure, and this assignment will be treated as the transfer of the relinquished property to the QI. This will avoid transfer taxes in many, but not all, states.
Completing the Exchange.
The replacement property must be identified in writing within 45 days after the foreclosure. As with a “normal” exchange, the property owner can identify up to 3 alternative properties, or any number so long as the total fair market value of the identified properties does not exceed 200% of the value of the relinquished property, which would be deemed to be amount of the debt relief for a non-recourse loan. As discussed above, however, the property owner will need to obtain new debt or invest new capital towards the purchase of the replacement property because there will be no exchange proceeds from the foreclosure of the relinquished property.
Finally, the property owner must remember that the replacement property has to be acquired in accordance with the regulations regarding the use of a QI. Because the QI holds no exchange proceeds and the property owner must supply the financing and/or cash investment for the replacement property, the property owner may erroneously think the QI’s role is over after the foreclosure of the relinquished property. However, the exchange will fail if the requirements are not satisfied. Typically, the assignment method will be used for the replacement property. This means that the property owner will enter into a purchase agreement for the replacement property, the property owner’s rights under the purchase agreement will be assigned to the QI, and the seller will be notified of the assignment.
As outlined above, a foreclosure sale can be structured as a Section 1031 tax-deferred exchange if the property owner has taxable gain due to a mortgage balance in excess of the adjusted tax basis. However, the property owner will still need to have other cash to invest, or readily available financing, in order to acquire the replacement property.
About the author
Mary B. Foster is President of 1031 Services, Inc., and has been involved in thousands of exchanges as an attorney and intermediary. Mary enjoys working on day to day exchange matters as well as structuring creative and complex exchange transactions. Mary can be contacted by email or by phone at (425) 646-4020.