When considering various workout strategies for distressed commercial property, one must carefully weigh the potential tax consequences of each option. Unfortunately, many commercial real estate property owners, understandably wanting to quickly put an end to a stressful situation, underestimate the potentially very expensive tax ramifications that could ensue from choosing a particular course of action. One example of this scenario is wrongfully assuming there will be no tax liability with underwater properties; those situations where the debt is greater than or equal to the value of the property resulting in either zero or negative equity at time of sale or other disposition.
Despite the lack of equity, a sale of property (which includes "forced sales" such as foreclosures, short sales or deeds in lieu of foreclosure) can result in taxable gain to the owner. You may reasonably ask, "How can I possible owe taxes on top of losing my investment?!" Let's say, for example, you are headed for foreclosure or a deed in lieu of foreclosure, each of which is deemed a sale for tax purposes at a value equal to the current outstanding amount of the debt. In this scenario, you would still realize a capital gains tax if the sales price is higher than the adjusted cost basis of your investment in the property. Additionally, whether the loan is recourse or non-recourse may further affect your potential tax liability. As you begin to see, there can be significant tax liability issues to consider even when your adjusted basis is low, or there is no equity.
The Solution: Zero Basis 1031 Exchange
Under IRC §1031, an investor may complete a 1031 Exchange to defer capital gains taxes and depreciation recapture by exchanging currently held property for a like-kind or similar commercial property, "held for productive use in a trade or business or for investment." Due to the exchange, the basis for the original property is carried forward to the new property. Additionally, you may structure a zero basis 1031 exchange when your property has negative equity and is relinquished. (See Private Letter Ruling 201302009, 01/11/2013, IRC §1031).
If you are facing foreclosure, for example, a zero basis 1031 Exchange is a viable option. In this case, you should find a replacement property with a fair market value equal to or greater than the current debt balance for the property foreclosed upon or relinquished. After the exchange is complete, any gain will be deferred, and you will end up with equity in another investment property rather than paying taxes.
"It can often times be challenging to find a like-kind replacement due to the lack of equity in the original property, but with the help of a seasoned and creative commercial real estate firm, it is probable that you will find the right combinations of debt and equity to make the exchange a success," explains Jack Rose, Chief Strategist at Breakwater Equity Partners, a commercial real estate advisory. Rose further suggests that you seek out firms that specialize in arranging these types of 1031 transactions as the timing and complexity of such an exchange make hiring an expert well worth the expense. As you can clearly see, it is absolutely essential to explore all of your tax consequences before proceeding with any workout or restructuring scenario. Once you know the tax aspects, you can logically weigh all of your options and implement a strategy, such as a zero basis 1031 exchange.
*Warning: This information is not intended to constitute legal, financial, or tax advice and should not be used in lieu of any professional's advice.