Debt Reduction: Beware The Taxman

June 19, 2010 Real Estate Information Real Estate Investing, 13

Borrowers all over the country are scrambling to negotiate a reduction in their loan balances, but many are  suddenly realizing that Uncle Sam is hitting them with unexpected tax liabilities  on any forgiveness of debt.

With the current downturn in the economy, this is a problem that will mushroom considerably over the next year or two as property values go down   and the number of loan workouts and debt restructuring skyrockets.

So is there any relief on the way  for tax-leery owners?  Maybe, but as we’ve discovered at financial Management Group in our dealings with numerous Los Angeles property-management.html">commercial property management clients, it depends on several factors concerning the property.

foreclosure Investing

Consider, for example   the recent New York case involving Manhattan’s Stuyvesant/Peter Cooper Village. The owner found himself experiencing  financial difficulties and offered to turn over the property in a deed-in-lieu of foreclosure. Not surprisingly  , the lender  moved to   foreclose. You think there was a big tax liability to follow? Not in this example.

Why?

Because in this  particular situation , the property owners avoided a tax liability on the forgiveness of debt because they  had a cost basis in the property of over $5 billion which  far exceeded   the $3 billion owed.

Additionally, the transfer of ownership triggered New York’s transfer tax, assessed at 3.025% of the mortgage. In this case, however, the parties involved realized that their tax load could be reduced if the entity that owns the property were transferred, rather than the property itself. The transfer tax liability, which would have come to $90 million, was reduced to about $60 million and was carried by the lender.

The above scenario is not always the case.  For example,  a property purchased in 2004 for $50 million that appreciated to,  let’s say  , $70 million three years later may have tempted the owner to borrow millions against it.  As a result, the mortgage balance now exceeded the owner’s basis and the IRS would tax the difference at ordinary income tax rates, not at the  capital gains rate. 

There have been other examples  where an investor had purchased a property through a 1031 tax-deferred exchange and carried his basis forward from the old property to avoid paying capital gains on the sale.  Now the newly purchased property is having financial problems and the lender forecloses on the property.  This investor will more than likely have a large tax liability  because his basis is from the old property and is much less than the current mortgage.   A better option in this case might have just been paying off the capital gains tax from the prior property. 

Remember , of course, that when you’re hit with a large tax, you can often defer payments for five years. After that, you’d have to pay 20% of the tax liability until the debt is paid.

refinance loans

 An alternate strategy   if you’re facing a large tax liability is to see if you can defer it by structuring something called a tax-deferred exchange.  In such a deal, however, you’ll have to have some equity as well as the debt . So if your equity is low—a common problem these days— You might find it challenging to successfully structure such a transaction.

If you’re finding yourself upside down on a commercial property, the best idea is to sit down with an experienced commercial property advisor and your tax accountant to work through all your options. The more  experience your advisor brings to the table  , naturally, the better off you’ll be.

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