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.
Given the present state of the economy, this is a problem that will become more and more common over the next year or two as property values recede and the number of loan workouts and debt restructuring goes through the ceiling.
So is there any hope in sight for tax-leery owners? Maybe, but as we’ve discovered at Financial Management Group in our dealings with numerous Los Angeles commercial property management clients, it depends on several factors concerning the property.
Case in point: the recent New York case involving Manhattan’s Stuyvesant/Peter Cooper Village. The owner had ran into financial difficulties and offered to turn over the property in a deed-in-lieu of foreclosure. Not surprisingly , the lender filed to foreclose. You might have expected the owner to be immediately hit with a huge income tax liability, but in this case, one did not arise.
Why?
Because in this particular situation , the property owners avoided a tax liability on the forgiveness of debt since the owners 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 lowered 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.
Now, of course, not all such situations turn out this way.. 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 expected capital gains rate.
Another example would be 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. Suddenly, for whatever reason, the owner finds himself in financial problems and the lender forecloses on the property. This investor will more than likely find himself looking at a significant tax bill because his basis is from the old property and is much less than the current mortgage. He would have better off paying the capital gains from the sale of 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 tax is fully paid.
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. The downside is that such deals require equity as well as debt. So if your equity is low—a common problem these days— it’d be difficult 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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