Using 1031 to defer capital gain taxes in foreclosure

Regrettably given current challenging market conditions, some investors may be faced with the prospect of being unable to cover monthly mortgage payments and operating expenses on their investment properties, in which case they will likely be faced with their lender at least threatening foreclosure. Investors in this situation will have a multitude of concerns from deteriorating credit ratings to loss of the equity they put into the properties. At best, if they want to retain the property, they may be able to obtain the lender's consent to restructure the loan. If the lender is unwilling to restructure the loan or if the investor does not wish to retain ownership of the property, allowing the bank to foreclose (or deed in lieu) may be the investor's best option. Of course, this too may depend on whether the lender has recourse against the investor for any shortfall liability and, if so, whether the investor can obtain the lender's agreement to a non-contested foreclosure in exchange for being released from any shortfall liability. Unfortunately, for many investors, there is yet one additional adverse consequence that can arise in the above circumstances that may also be significant. Even if the lender is cooperative and the investor is able to reach agreement with the lender to accept the property in full satisfaction of any outstanding indebtedness, the investor may have a capital gain tax liability arising out of such an agreement. A tax liability may arise in the above situation if the indebtedness encumbering the property is greater than the investor's basis. A taxable event may occur if a lender forecloses on property or accepts a deed in lieu of foreclosure. In the case where a lender accepts the property in lieu of foreclosure and in full satisfaction of the outstanding indebtedness, the investor will realize a taxable gain to the extent the outstanding indebtedness exceeds the investor's basis in the property. Similar consequences occur where debt is forgiven in that the investor is deemed to receive taxable income equal to the amount of the debt forgiven. In these instances, investors have a capital gain tax liability even though they received no cash with which to pay the liability. Remarkably, all is not lost to an investor who has some cash and would like to continue to invest in real estate. In spite of the fact that the property may be sold to satisfy a debt, if the transaction is properly structured, the investor could elect to perform a §1031 tax deferred exchange with the mortgaged property being the relinquished property. It is important that the transaction be structured as a deed in lieu of foreclosure so that the property is deeded to the lender. If the property is foreclosed or the note and mortgage simply assigned to the lender, the transaction would not likely qualify either because no "sale or exchange" occurred or because mortgages and notes do not qualify as "like kind" property under §1031. With a deed in lieu of foreclosure, it is critical that the exchange documents be executed by the investor prior to the property being deeded to the lender as the deed to the lender commences the running of the 45 day identification period and the 180 day exchange period. During the exchange period, the investor must acquire replacement property of equal or greater value to the value of the relinquished property in order to 100% defer his or her tax liability. For example, if an investor owns property worth $10 million subject to $10 million of debt with a basis of $3 million deeds the property to a lender in satisfaction of the debt, the investor will realize a taxable gain of $7 million. If the investor performs a §1031 exchange and purchases replacement property within the exchange period valued at $10 million or more (less exchange expenses), the investor will be able to fully defer any gain. The obvious hurdle to performing such an exchange is that the investor must have enough cash available to make a down payment on the replacement property and be able to finance the remainder of the purchase price. The upside is that since the relinquished property was mortgaged to 100% of its value, the investor could potentially perform a 100% deferred exchange without putting any cash into the replacement property (in the event a lender is willing to finance 100% of the property's value or the seller provides such financing). The above consequences highlight the need to involve legal and tax advisors in connection with all investment decisions and early in the process as the failure to do so may result in an investor incurring unintended tax liabilities that could have been deferred had the transaction been reviewed early on by the right professionals. As with any transaction, there may be reasons that an exchange is not beneficial to any particular investor (the investor has capital losses which could be used to offset gain). Again, consulting with the appropriate advisors prior to any transaction will ensure that whatever action is taken will have the best economic outcome for the investor. Pamela Michaels, Esq., is an attorney and a vice president of Asset Preservation, Inc., Manhattan, N.Y.