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Posts Tagged ‘deed in lieu of foreclosure’

What do I do if my TIC is in trouble?

Saturday, February 20th, 2010 by Moore McLaughlin

Alexandra L. Hart, CES® 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.tic-foreclosure

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, CES® by e-mail at AHart@AllStates1031.com or by phone toll-free at 877-395-1031 ext. 217.

How To Purchase 1031 Replacement Property at an Auction

Monday, February 15th, 2010 by Moore McLaughlin

Alexandra L. Hart, CES® at All States 1031 Exchange Facilitator, LLC has been asked several times recently about how to buy replacement property at an auction.  While there is certainly nothing in section 1031 that specifically prohibits or disqualifies such replacement property, the real problem lies in the process and logistics of the auction process.  Most of the auctions are being held in connection with a mortgage foreclosure.

AuctionAt most auctions, the bidders must show a certified check in a certain minimum amount, such check being evidence of the ability to make a deposit payment.  Other than proof of ability to pay, and proof of identification, very little is required.  Standard purchase and sale agreement are not typically used.  The issues affecting the 1031 exchange include meeting the identification rules, assignment to the qualified intermediary of the right to buy the replacement property, and potential constructive receipt and boot issues.

In many auctions outside the 1031 arena, the bidders will bring a certified check payable to themselves.  If they are the successful bidder, they will endorse the check to the seller or the auctioneer.  In the 1031 world, if the QI issues a certified check payable to the exchanger, and then the exchanger endorses the check to the auctioneer, the IRS will likely assert that such amount was received by the exchanger and taxable as boot.  Furthermore, the payment could possibly disqualify the entire exchange as a distribution in violation of the specific restrictions (known as the g(6) limitations (see Treasury Regulation Section 1.1031(k)-1(g)(6)) on payments from the exchange account.  In other words, issuing a check payable to the exchanger is not a good idea.

One alternative is, prior to the auction, ask the auctioneer for the name of a title company they trust and have the QI place the exchange funds with them subject to the acceptance of the bid.  The exchanger can take blank assignment of contract documents with them to the auction to be executed in the event that they are the successful bidder.

Another alternative is to have a certified check issued by the QI to the auctioneer to be used in the event of a successful bid.  Otherwise, the check is returned to the QI.

Or, if the exchanger is trading up in value, the exchanger can use his or her own funds.

Other solutions could be found in particular situations.  If you are contemplating purchasing a replacement property through the auction process, be sure to contact Alexandra L. Hart, CES® or F. Moore McLaughlin, Esq., CPA, CES® to determine the best alternative.  You can reach Alexandra at AHart@AllStates1031.com or toll-free at 1-877-395-1031 extension 217.


Piling On: Foreclosure Sales Can Trigger Unexpected Tax

Thursday, November 15th, 2007 by Moore McLaughlin

Foreclosure rates have increased dramatically recently, and the trend is expected to continue through the last quarter of 2007. Many foreclosed owners suffer a second indignity when they discover that they owe a substantial capital gains tax resulting from the foreclosure. The final straw comes when they learn that the gain could have been deferred through a 1031 exchange despite the fact that there was zero equity from the foreclosed property.

When appreciated real estate is to be sold, many taxpayers are aware that they can defer income tax on the gain by entering into a like-kind exchange under Section 1031 of the internal Revenue Code. When real estate is to be foreclosed on, however, few taxpayers are aware that they too may need a 1031 exchange since they may have “phantom income” if the debt encumbering the foreclosed property exceeds the fair market value of the property.

For income tax purposes, a foreclosure (and a deed in lieu of foreclosure) is treated as a sale despite the involuntary nature of the proceeding. Gain from the “sale” is equal to the amount realized over the adjusted basis of the property.

With nonrecourse debt, the amount realized is equal to the outstanding amount of the nonrecourse debt, regardless of the current fair market value (”FMV”) of the asset (i.e. the “phantom gain”). When recourse debt is discharged through a foreclosure, the transaction is treated as (i) a sale of the real estate for its FMV (with gain equal to the difference between the FMV and adjusted basis) and (ii) cancellation of debt (”COD”) income, taxed at ordinary rates, for the amount of the debt relieved that exceeds the FMV. The tax code does provide some exceptions to recognition of COD income for insolvent and bankrupt taxpayers, in exchange for reduction of certain tax attributes.

IRC § 1031 provides that no gain or loss will be recognized on the exchange of properly held for productive use in a trade or business or for investment if the property is exchanged for property of a like kind. The regulations which define the term “like kind real property” generally consider US real property to be of like kind to all other US real property. There is no requirement in the Code or the Regulations that a taxpayer must have equity in the property being transferred for the exchange to be valid.

A taxpayer engaging in an otherwise valid like kind exchange will recognize gain if “boot” is received. Boot includes cash and the fair market value of any property other than qualifying like kind property. Boot also includes any relief from debt on the property-being sold, unless the taxpayer acquires a property with an equal amount of debt.

If a foreclosure or deed in lieu of foreclosure is inevitable, then the real estate owner can opt to enter into a deferred exchange transferring the distressed property to a qualified intermediary (”QI”). The QI disposes of the property by allowing the lender to complete the foreclosure. The QI would receive no proceeds from the sale, and would therefore not be required to spend any funds on the replacement property. The replacement property would, however, need to have a FMV equal or greater than the foreclosed property, and debt equal to or greater than the debt on the foreclosed property in order to avoid the receipt of boot.

Since it is doubtful that the real estate owner will be able to obtain 100% financing for the replacement property, it will be necessary for the owner to invest additional capital into the replacement property. The taxpayer and the QI would effectuate the purchase like a traditional exchange, with the exception being that the taxpayer would bring any required equity to the closing. The cost of expending additional capital, however, should be weighed against the tax resulting from the phantom income that would otherwise be due. In most cases, it makes sense to do the exchange. A taxpayer thinking about entering into this type of exchange should consult with a tax professional.