TAX PITFALLS ON DISTRESSED PROPERTY

RANCHO CORDOVA, California -- August 20, 2009 -- Foreclosure!  It’s no secret that the real estate market has significantly declined over the past 24 -36 months.  Pressure to reduce rents, increased vacancies, the ever tightening credit crunch, and the overall decline in the economy have left once viable real estate holdings struggling to break even.  Foreclosures have become a common occurrence in today’s market place, but the income tax effect of foreclosures and loan modifications are not commonly known.

Effect of Foreclosure

As an example, assume a property was purchased five years ago near the peak of the real estate market for $8,000,000.  The property is now worth $5,000,000 with related debt in the amount of $6,000,000.  In this same example, assume the owner also exchanged into the property with an adjusted basis of $4,000,000.  Should the property be forced into foreclosure, the tax impact could have varying outcomes depending upon the type of debt related to the property.

If the debt related to the property is nonrecourse debt, the owner would have to recognize gain on the disposition of the property of the difference between the adjusted basis in the property and the amount of debt on the property.  In this case, the owner could have $2,000,000 of income ($6,000,000 - $4,000,000).

Should the debt be considered recourse debt, the gain will be split between gain on the disposition of property and cancellation of debt income (CODI). To calculate the gain, the amount used for gross proceeds is the lesser of the fair market value (FMV) of the property or the amount of debt on the property. This would result in a gain of $1,000,000 ($5,000,000 - $4,000,000). The amount of the debt in excess of the FMV, $1,000,000, would be considered CODI. CODI is ordinary income but is not always taxable. There are potential income exclusions for insolvency, bankruptcy and qualified real property business indebtedness, but other tax attributes may need to be reduced if the exclusion is used.

Additionally, when property is owned by a partnership or limited liability company, additional income tax consequences may result – often very unexpected by the partner or member.

Effect of Restructured Debt

Should a lender choose to work with the property owner in order to reduce the principal amount of debt or sufficiently modify the terms of the debt, the owner often faces the possibility of additional CODI as a result of the restructure.

What could be worse than losing a property to foreclosure? … Losing the property and incurring a significant income tax liability!! Every situation is different so be sure to talk to a real estate tax professional to fully understand the tax impact ahead of time and what might be able to be done to mitigate tax ramifications. For more information please contact our office.