Commercial real estate use 1031 exchange to defer capital gains taxes on foreclosure property.
1031 Option for Foreclosure Deals
November/December 2010: Commercial News Round Up
News briefs to keep you in the know about the commercial real estate industry.
By Mariwyn Evans November 2010
reprinted courtesy Realtor Magazine 11/10
As many commercial property owners face foreclosure or opt for deeds in lieu of
the same, using a 1031 exchange to acquire a zero-income property may offer a way
to defer the capital gains taxes due on the lost asset.
The strategy isn’t new, says Lou Weller, national director of real estate transaction planning at Deloitte Tax LLP, who first used the strategy during the commercial real estate meltdown of the early 1990s. But as markets fall, it’s made a comeback, and it can be a money saver.
When you’re trying to decide if a zero-income property exchange is right for your client, determine how much in capital gains the foreclosure will generate. The catch here is that for tax purposes, it doesn’t matter if the value of the property is less than the debt.
You can still have a gain, Weller says. If a property is financed with a nonrecourse mortgage and then foreclosed or deeded back to the bank, the debt amount is treated as the sales price, and the owner’s gain is equal to the excess of the debt over the tax basis. (Note that different rules apply for recourse debt, creating the possibility of a combination of capital gain/loss and ordinary income from the cancellation of debt when recourse debt is foreclosed.)
However, there is an option that may help some owners when a foreclosure or deed in lieu creates taxable capital gain. By exchanging the soon-to-be foreclosed property for another one equal in value to the amount of the loan, the owner can defer the capital gain and still satisfy the bank.
This time the catch is that since the owner won’t receive any cash from the foreclosure or deed in lieu, he doesn’t have cash to pay for the exchanged property. That’s where the zero-interest replacement property comes in.
A zero-interest property is one that is highly leveraged (as much as 90 percent LTV) and leased on a long-term triple-net basis to a credit tenant—think Walgreens or Starbucks. All the income from the property goes to cover the debt service and the tenant pays all the expenses, so there’s no positive or negative cash flow.
Because of the high leverage on a zero-interest property, only a relatively small amount of equity is needed to satisfy the boot in the exchange, provided that the mortgage on the asset is assumed. Even though they’ll receive no cash boot from the transaction, they’ll need to contribute somewhere in the neighborhood of 10 to 15 percent of the replacement property’s value to finalize the exchange.
Because loans on zero-interest properties are amortized for 20 to 25 years, at some point, an owner will have to start paying a sizeable portion of the principal as well as the interest. Since that portion of the payments isn’t tax-deductible, the owner will have phantom income from the property, which will be taxed at the owner’s ordinary income.
For the most part, the zero-interest exchange works best for corporations, which don’t receive a capital gains benefit, Weller says.
reprinted courtesy Realtor Magazine 11/10, original link www realtor.org/rmocommercial/articles/2010/1011_commercial_newsbriefs
Disclaimer: we have no information if the content of these articles is correct
or not, we are reprinting them only for interest and general information. For
legal advice please contact an attorney.
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