TO: REAL ESTATE PROFESSIONALS
RE: HOW TO SELL OVER-ENCUMBERED COMMERCIAL REAL ESTATE AND STILL AVOID TAXES
Clients selling over-encumbered commercial real estate may have a large income tax liability on that property’s sale due to the real estate’s low tax basis and the property’s large amount of indebtedness. The result is that clients receive very little or no cash on the property’s sale, but may have to pay a large amount of income tax. Allowing the real estate to be foreclosed upon or abandoned will not solve the client’s tax problem since these acts often trigger taxable gain. Lenders in the business of lending money are required under the Internal Revenue Code to report to the IRS a property’s foreclosure or abandonment, and certain lenders are required to report to the IRS a borrower’s discharge of indebtedness income.
Clients owning commercial real estate with large amounts of debt can solve their tax problems by using the tax plans discussed below. 1
1. Do a Section 1031 Exchange Prior to the Property’s Foreclosure in Order to Avoid Taxable Gain Recognition .
Instead of allowing the property to be foreclosed, clients can enter into a Section 1031 tax-free exchange by which the client exchanges its troubled relinquished real estate and receives in the tax free exchange, as replacement property, real estate with equal or more indebtedness. One of Section 1031’s requirements is that there must be an “exchange” of the relinquished and replacement properties. If the relinquished property has no equity because that property’s debt exceeds the relinquished property’s value, then there is the tax issue as to whether this Section 1031 “exchange” requirement has been satisfied. Additionally, to make this exchange work, the client may have to contribute additional cash to purchase the replacement property, or the buyer who purchases the client’s troubled relinquished property may have to inject additional cash into this relinquished real property. A client can gain more time to avoid foreclosure and to complete their Section 1031 exchange, by filing for federal bankruptcy protection.
2. A Partnership Can Avoid Taxable Gain From its Over Encumbered Real Estate by Admitting a New Partner to the Partnership in Exchange for That New Partner’s Cash Contribution .
For over-encumbered real estate owned by a partnership or limited liability company, a new cash contributing partner could be admitted tax free to the partnership and the original partners’ percentage interests would then be reduced. The partnership then would proceed to utilize this newly contributed cash to cure the real estate’s debt problems and to make payments on the loan. The original partners remain as smaller percentage interest partners so as to avoid gain recognition, and thus are able to defer their built-in taxable gain. Upon the new cash contributing partner’s admission, the partnership may elect to book up (or not book up) the value of the partnership’s assets, or which 704(c) method to use, all of which will affect the out of pocket tax costs and tax benefits to the original initial partners and to the newly admitted partner. 2 In order for these original partners to avoid gain recognition from an imputed distribution of cash (based upon the reduction of their share of the partnership debt when the new partner is admitted), these original partners must retain for tax purposes an adequate share of the partnership debt.
3. Increase the Income Tax Basis of the Real Estate By Having the Partnership First Acquire, and Then Distribute, a New Property .
For over-encumbered real estate owned in a partnership, the partnership could purchase a new property and then distribute such new property to a partner in complete redemption of that partner’s partnership interest. The resulting redemption of a partner in exchange for the new property causes the partnership (which is owned by the remaining partners) to receive an increased tax basis in the partnership’s retained highly encumbered property under Internal Revenue Code Sections 734 and 754. 3 Thus, the partnership reduces, or even eliminates, the substantial taxable gain inherent in its retained real estate by this tax basis increase. The partnership obtains the monies to purchase the new property by a capital contribution from the redeemed partner plus monies borrowed from a third-party lender.
4. Have the Client Sell the Property in Exchange for a “Wrap Around” Installment Promissory Note and Deed of Trust .
Selling property for a “wrap-around” promissory note and deed of trust enables the client to defer recognizing taxable gain, and instead report the real estate’s inherent taxable gain over a period of years. Under a “wrap-around” deed of trust, the client, after selling their property, continues to remain as the obligor on the property’s deed of trust, and the client continues to make the payments under that deed of trust. In the sale a second deed of trust is “wrapped around” this first deed of trust so that the property’s buyer is obligated to pay monies to the client/seller (and not pay directly the first deed of trust lender). Thus, the client’s tax position is that the “wrapped” first deed of trust was not assumed or taken “subject” to by the buyer under the Section 453 installment sale rules. 4 One practical business issue with this tax plan is that the client/seller may have difficulty, in convincing a buyer to “trust” that the client will continue to make payments to the first deed of trust lender under the “wrap-around” arrangement. In order for a “wrap-around” deed of trust to be respected for federal income tax purposes, the client should solely remain obligated to make the payments under the first deed of trust, and the client/seller should in fact directly make these first deed of trust payments to the lender (and these first deed of trust payments should not be made by the property’s buyer). 5
5. Avoid Taxable Gain by Having the Lender Take Back a Partnership Interest in Exchange for that Lender Cancelling the Partnership’s Debt .
The lender may agree to take back a partnership interest in the borrowing partnership in exchange for cancelling that partnership’s debt (recourse or nonrecourse). The borrowing partnership does not have cancellation of indebtedness income (known as “COD Income”) to the extent of the fair market value of the partnership interest received by the lender. However, the partnership realizes COD Income to the extent that the fair market value of the partnership interest received by the lender is less than the amount of the debt discharged. 6
6. Have a Friendly Third Party Acquire the Client’s Promissory Note From the Lender .
A client owning troubled property can avoid recognizing COD Income by having an unrelated , but friendly, third party acquire the promissory note from the lender. 7 The friendly party acquiring the debt can then allow the client a longer period of time to cure the debt default, and thereby have time to sell the property. To avoid COD Income being generated after the unrelated party acquires the promissory note, there should not be a “significant modification” of that promissory note after that promissory note’s acquisition by the unrelated third party.
7. If the Client’s Debt is Purchase Money Debt, Then That Debt Can Be Reduced Without the Client Having to Recognize Taxable Gain .
If the seller of the troubled over encumbered property had originally taken back from the client (the buyer/borrower) a deed of trust and promissory note (sometimes known as a “purchase money debt”), then to the extent of COD Income triggered by that debt’s reduction, the promissory note’s principal amount is reduced tax free to the client under Section 108(e)(5). 8 This tax-free exception for the reduction of purchase money debt applies only if the seller of the real property takes back the debt, and this exception does not apply where a third-party lender (such as a bank) made the original loan.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with Treasury Department regulations, we inform you that any U.S. Federal tax advice contained in this Newsletter is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
2 In many cases the deeds of trust encumbering the property will eliminate any equity value to the existing original partners. Thus, upon the admission of a new partner, the capital accounts of these original partners may not have to be booked up. The capital account of the original partners with its minimum gain remains with the original partners to be recognized by these original partners when the property is eventually sold or as the principal amount is paid down on the deeds of trust (or is forgiven).
3 There are tax issues, such as the partnership disguised sales rules that must be reviewed if this tax plan is used.
4 The use of wrap-around deeds of trusts and mortgages was established in earlier Tax Court cases, but the IRS attempted in Temporary Treasury Regulation §15A.453-1(b)(3)(ii) to deny the use of these “wrap-around” deeds of trust. These Temporary Treasury Regulations were, however, found to be invalid in the Tax Court case of Professional Equities, Inc. , 89 T.C. 165 (1987), acq. 1988-2 CB1.
5 Another tax issue with utilizing an installment note is that under Section 453A, where the installment obligations exceed $5,000,000, interest must be paid on the deferred tax liability. Fortunately, this $5,000,000 amount is applied on a partner by partner basis (rather than only once at the partnership level). Thus, in a multiple partner partnership, paying this §453A interest amount on the deferred tax is often avoided.
6 Prop. Reg. §1.108-8 states that the fair market value of the partnership interest can be based upon its “liquidation value” provided certain conditions are met.
7 If instead a party “related” to the property owner for tax purposes were to acquire the property owner’s debt from the lender, then that property owner/debtor would be treated for tax purposes as having acquired its own indebtedness, which in turn would generate COD Income.
8 This rule does not apply where the original property’s seller has assigned the debt. Also, this rule does not apply where the debt reduction is in a Title 11 (bankruptcy) case or where the property owner/buyer is insolvent.
Prop. Reg. §1.108-8 states that the fair market value of the partnership interest can be based upon its “liquidation value” provided certain conditions are met.
If instead a party “related” to the property owner for tax purposes were to acquire the property owner’s debt from the lender, then that property owner/debtor would be treated for tax purposes as having acquired its own indebtedness, which in turn would generate COD Income.
This rule does not apply where the original property’s seller has assigned the debt. Also, this rule does not apply where the debt reduction is in a Title 11 (bankruptcy) case or where the property owner/buyer is insolvent.