Exchanges & Foreclosures
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EXCHANGES & FORECLOSURES
Yes, it is true. If you owe a debt and it is cancelled or forgiven, you must include the amount realized as gross income. The foreclosure of mortgaged property held for the productive use in a trade or business will result in a taxable event, (gain or loss) notwithstanding the fact that the foreclosure may be involuntary or voluntary as in the case of a deed given in lieu of foreclosure.
If the foreclosure results in a gain, gain will be recognized on the date of the foreclosure to the extent of the amount realized by the mortgagor less the adjusted basis in the property. Exceptions to this general provision provide relief to some taxpayers who are in Title 11 bankruptcy, taxpayers who are insolvent at the time of the foreclosure, and foreclosures on certain types of farm debt.
In general, the amount realized equals the aggregate amount of the debt, accumulated interest and costs that is forgiven or discharged by virtue of the foreclosure. For all practical purposes, the foreclosure is considered a sale by the mortgagor at a gross sale price equivalent to the aggregate amount of such debt, interest and costs. However, if the mortgagee retains the right to seek a deficiency judgment pursuant to the terms of a recourse note then the amount of such deficiency is not included in the amount realized and is not subject to tax at the time of the foreclosure.
IRC §1001 provides that the gain "from the sale or other disposition of property is the excess of the amount realized therefrom over the adjusted basis of the property". Alternatively, IRC §1031 provides that "no gain or loss shall be recognized on the exchange of property held for the productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for the productive use in a trade or business or for investment"
Is an Exchange a viable alternative to reduce or eliminate current capital gain tax liability that may result from a foreclosure? From a technical and theoretical standpoint, IRC §1031 may be applied to postpone the recognition of gain that results from the amount realized in a foreclosure. However, an Exchange may not be practical solution.
In many applications, the taxpayer's equity in the relinquished property will be zero, debt will be in excess of fair market value of the foreclosed property. Additionally, the Exchange Intermediary may not receive any cash proceeds at the time of foreclosure for the purchase of replacement property and the taxpayer may not have the ability to acquire new debt in the acquisition of such property. The taxpayer may be leaping from one frying pan to the next without hope of curing the cause of the original foreclosure.
IRC §1031, however, does not recognize any of these issues. In fact, if the taxpayer, 1) enters into an Exchange agreement with a Qualified Intermediary, 2) Conveys the relinquished property to the Intermediary subject to the debt before the foreclosure, 3) properly and timely identifies qualifying replacement property, 4) receives qualifying replacement property from the Intermediary prior to the termination of the Exchange period, and, 5) does not receive any net boot in the Exchange, then the total tax liability associated with the foreclosure will be deferred until such time as the taxpayer subsequently disposes the replacement property in a taxable transfer. The non-recognition provisions of IRC §1031 apply regardless of the fact that the taxpayer held no equity in the relinquished property. The provisions are not waived or violated even if the Qualified Intermediary receives no cash proceeds at the time of the foreclosure and the code and regulations do not anticipate the qualifications of the taxpayer to hold qualifying replacement property.
As a case in point, corporate taxpayer, who is a non dealer in real estate, acquires an office building in 1980 for $5,000,000. By 1989 the building has appreciated to a fair market value of $11,000,000. Also in 1989 the taxpayer refinances the property leveraging 80% non-recourse debt and draws tax free net cash in the amount of $3,800,000.
Shortly after refinancing, taxpayer, along with many other real estate investors, watches as his net worth is eroded by a national recession. Tenants are vacating the property and negotiating discounted leases. Property values are plummeting at a record pace and the rate of occurrence of foreclosures and bankruptcies skyrockets.
By the end of 1993 the fair market value of the taxpayers property stabilized at $5,500,000 and the property generates net income of about 60% of the debt service. The taxpayer had been in default on the non-recourse debt for over a year and was facing immediate foreclosure. His adjusted basis in the property was $2,000,000.
If the lender forecloses the amount realized by the taxpayer will be $11,000,000, the amount of outstanding non-recourse debt plus accumulated interest and costs. Taxpayer will realize gain to the extent of the amount realized less the adjusted cost basis, realized gain of $9,000,000.
The taxpayer has the capability of acquiring qualifying positive cash flow replacement property in the $11,000,000 price range and elects to avoid the tax consequences of the foreclosure by accomplishing an Exchange. Prior to the foreclosure, taxpayer deeds the property to a Qualified Intermediary pursuant to the terms of an Exchange agreement.
Following the foreclosure the taxpayer identifies replacement property which is subsequently acquired by the Intermediary and transferred to the taxpayer.
The taxpayer will avoid the immediate tax consequences of the foreclosure if he acquires replacement property, in a qualifying exchange, with a value equal to or greater than $11,000,000. He may acquire the replacement property fully or partially leveraged, with or without equity. The property may be acquire subject to existing debt or with new recourse or non-recourse debt.
In summary, if the taxpayer has the capability of acquiring replacement property, then an Exchange should be considered as a solution to the potential tax liability created by a foreclosure.
This information is not intended to replace qualified legal and/or tax advisors. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.
