Tax consequences of solution transactions.
Although the frequency of real estate workouts, foreclosures and bankruptcies has increased greatly in recent years, the enormous impact of taxes on these types of transactions remains a virtual mystery to even some of the most sophisticated property owners.
The importance of tax issues on workouts, foreclosures, and bankruptcies cannot be overstated. What might appear on the surface to be a satisfactory workout or other solution to a problem posed by financially distressed property could result in financial disaster for the property owner/debtor when tax implications are taken into account.
Indeed, an owner may be shocked to find a huge tax bill waiting for him even after he has lost his property. In fact, in New York State certain taxes must be paid in advance in order for a transfer of property to be implemented at all.
The many subtleties of the tax laws on the federal, state and local levels must be considered to determine if a negotiated deal with a lender is as good as it looks for the property owner.
This series explores the basic tax rules in this area and discusses the major tax issues involved in a workout situation. Although the series is not intended as legal advice, it will provide the property owner with a useful framework which will enable him to work with his professional advisors to address his specific circumstances. Knowledge in this area is essential for every owner of financially distressed properties who fosters any hope of emerging in an economically viable position.
This first article is intended as an overview of various options for distressed property owners and the importance of advanced tax planning for each option. The second article will discuss the income tax consequences of the various options for the distressed property owners. The third article will discuss certain income tax planning techniques available for property owner who realize income from the discharge of debt. Finally, the fourth article will discuss gains tax and transfer tax consequences to an owner who surrenders his property.
From Boom To Bust
While many factors -- from overbuilding to a static economy -- deflated the boom cycle, a crucial harbinger of things to come occurred in 1986 with a major rewriting of the Internal Revenue Code. The new tax law was very harsh on real estate investments. Tax incentives that encouraged investment in real property (such as favorable depreciation rules) were eliminated. Moreover, the passive loss rules were enacted to prevent losses from rental real estate being used to offset income from other sources. In addition, the at-risk rules were extended to real estate. All of these resulted in real estate being a less attractive investment.
Finally, the problems in the banking industry compounded the downfall. Even developers with viable projects found that their sources of financing had dried up. With regard to existing loans, there was no normal and traditional cooperation between the lender and the developer in the course of a project in regard to extensions and modifications to deal with changing events. Even existing mortgages on rental properties on which the debt service was being paid currently could not be refinanced or extended at maturity, thereby precipitating further defaults, foreclosures and bankruptcies.
Due to the recession, the ability of tenants to pay rents declined and there was less demand for vacant and new space. Landlords granted midlease rent reductions for existing tenants in order to preserve occupancy, and offered various concessions for new tenants who generally did not sign, in any event.
The end result was a glut of office space, skyrocketing vacancy rates and owners with such poor cash flows from their buildings that they could not pay their carrying costs. Real estate workouts, bankruptcies and foreclosures became everyday events. New structures were rare, restructures commonplace.
There can, however, be life after foreclosure -- but it requires careful planning, especially regarding taxes. There are basically two methods of dealing with financially distressed properties. The first, surrendering the property, can be accomplished through foreclosure, transferring the property to the lender by deed in lieu of foreclosure, or bankruptcy, with the lender releasing all or part of any personal liability for a deficiency. The second method is the restructuring of the terms of the debt with the borrower retaining the property.
In each of these alternatives, taxes play a tremendous role. For example, on the surface, the surrender of a poorly performing property to cancel the debt appears to be a solution with little or no cost to the owner/debtor. But if the amount of debt on the property is greater than its fair market value, the difference is considered to be taxable income by the Internal Revenue Service. So if the debt exceeds the fair market value by $1 million, for example, Federal income tax of more than $300,000 can be incurred. In addition, state and local income and transfer taxes can significantly add to the tax cost of the surrender.
Poorly planned workouts can have financially devastating tax consequences as well. For instance, a lender may agree to substantially lower an interest rate on a property loan to enable the owner to meet payments. In return, the property owner may agree, for example, to pay the lender a certain percentage of the proceeds when the property is sold.
While this transaction sounds good for both the lender and the debtor, the tax consequences may be highly adverse. The IRS views interest rate reductions below a certain level, or the addition of certain contingencies, as a reduction of principal, or discharge of debt, which results in taxable income to the owner. If the owner is aware of the tax implications of this type of a workout agreement, he can often work with his professional advisors to formulate a workout agreement in which tax can be avoided or deferred and yet have substantially similar financial consequences for both the owner and lender.
Next Week: The tax consequences of surrendering property or restructuring.
Stephen S. Ziegler is a partner at the New York City tax law firm of Ziegler, Sagal & Winters. He is a nationally recognized authority on the tax aspects of complex real estate transaction . Allan Winters and Lanny Sagal also contributed to this article.
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|Title Annotation:||First part of four series article|
|Author:||Ziegler, Stephen, S.|
|Publication:||Real Estate Weekly|
|Date:||May 27, 1992|
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