Alexandra L. Hart, CESŪ and I have been asked this question almost every other day for the past several months. With the national commercial real estate and financial markets in turmoil, many investments that seemed solid only a year or two or three ago are now floundering. Lenders are beginning foreclosure proceedings or are negotiating with the owners to take back a deed in lieu of foreclosure. Buildings are being sold in so-called short sales. And, lenders are selling off the promissory notes at deep discounts. In other instances, the banks are not taking any immediate action, but the sponsors are offering to buy out investors for the amount of their investment. Sometimes, individual investors are concerned and want to sell their interests, thus giving the other co-tenants an opportunity to buy a larger percentage for a small amount.
The question that we are continually asked is “What is my tax exposure?” As a tax lawyer, I have been trained to answer “Well, it depends.”
In every TIC I know of, the property is encumbered by non-recourse debt. Non-recourse debt is a loan made by a lender (could be a bank, an insurance company, a pension plan or some other type of lender) which debt is secured only by the property. The key feature of non-recourse debt is that no one is personally liable for the debt and the lender can look only to the property for repayment. As long as the rents are able to cover the expenses of the property and make the mortgage payments, then the lender typically feels comfortable. However, if the cash flow only covers the expenses and the investors do not receive any distributions, then the investors are not comfortable. Once the cash flow fails to cover the expenses, then the trouble really begins.
Sometimes the sponsor or property manager will make a cash call. If one or more of the owners is not willing or able to contribute enough cash, then the tenant-in-common agreement generally provides that the non-contributing owner either has to sell his or her interest, or the property has to be sold. In any event, if there is insufficient cash to cover the expenses, the lender will eventually take action.
In most of these cases, the TIC investors do not contribute additional cash. Thus, the lender starts the process of taking back or selling the property. Because the debt is non-recourse, the lender cannot go after the TIC owners, and cannot force the TIC owners to pay any money. So, the TIC owners generally lose the property, and their investment, but that is the extent of their losses.
These investors are convinced that they have sustained a loss for tax purposes. In almost every instance, that is not the case. For tax purposes, if a property that is encumbered by non-recourse debt is foreclosed upon or transferred back to the lender by a deed in lieu of foreclosure, the investor is treated for tax purposes as if he or she sold their interest in the property for their share of the non-recourse debt. For tax purposes, this is known as the amount realized. Taxable gain is calculated as the amount realized minus the adjusted tax basis of the property.
So, the next issue is to determine the investors’ adjusted tax basis in the property. Most of the TIC owners acquired the TIC interest as a replacement property in a 1031 exchange. If so, then their adjusted tax basis in the TIC interest is determined, in whole or in part, based on their adjusted tax basis in the property or properties that they sold in the 1031 exchange(s). If the investor traded up in value on the 1031 exchange, then the investor may have added to his or her adjusted tax basis. Any investor facing this dilemma should consult a qualified CPA or tax attorney who can make these complicated calculations.
Non-recourse debt that is forgiven does not result in cancellation of indebtedness income (”COD income”). COD income can be generated only from recourse debt. COD income is subject to a completely different set of tax rules. So, investors should not become confused with how the COD income rules operate.
The character of the gain on the foreclosure or deed in lieu of foreclosure of a TIC interest is likely to be capital. The holding period of the TIC interest is determined, to some extent, based upon the holding period the investor had in his or her relinquished property or properties from the 1031 exchange. However, if the investor traded up in value, he or she could have a split holding period. In order to enjoy the lower long-term capital gains tax rates, the property has to have been held for more than twelve months. In calculating the 12-month holding period, the investor may be able to tack on the holding period from his or her relinquished property. Again, any investor in this situation needs to consult a qualified CPA or tax attorney.
Remember also that there is no bright-line test for how long a property has to be held to qualify as “held for investment” for purposes of section 1031. There is no 2-year rule, 1-year rule or any other hard and fast rule.
In summary, the investor is treated as having sold the TIC interest in an amount equal to his or her share of the non-recourse debt. The investor will recognize gain or loss on this deemed sale based on his or her adjusted tax basis. In addition, the investor must determine his or her holding period.
The good news is that for investors facing a large tax bill, they may be able to defer the tax by effectuating another 1031 exchange. Click here for more information about “coffin or “no equity” exchanges.
For more information about these issues, or to ask questions about a specific scenario, please contact Alexandra L. Hart, CESŪ by e-mail at AHart@AllStates1031.com or by phone toll-free at 877-395-1031 ext. 217.
Tags: 1031, 1031 exchange, All States, bankruptcy, boot, capital gains tax, Certified Exchange Specialist, CES, deed in lieu of foreclosure, gain, investment, investment property, IRS, Moore McLaughlin, QI, qualified intermediary, qualifying property, short sales, tax attorney, tax deferred exchange, Tenant In Common, TIC, zero equity
if the company that receives the cod income is insolvent, then wouldn’t there be no tax due?
You have identified the important distinction between recourse and non-recourse debt. You have a valid point if the debt is recourse debt. However, with the TIC investments, the debt is almost always non-recourse debt. COD income cannot be generated from non-recourse debt. The insolvency exception applies to COD income, none of which arises when the debt is non-recourse.
What happens if the bank forecloses, or a deed in lieu, and the entity that owns the tic is insolvent? Would taxes still be owed?