Did you know that losing a commercial property in foreclosure means that you will most likely also have to pay income taxes as a result?  Sounds illogical and most investors are shocked to learn about it.  But careful planning can help to at least minimize this additional insult. This article explains how property sales, loan modifications and investment losses are treated for tax purposes.

General

Taxable capital gains or losses for income tax purposes result from any sale of real property.  Sales include “forced sales” such as a short sale, deed in lieu of foreclosure, or actual foreclosure. To the extent there is debt on property in excess of a taxpayer’s adjusted tax basis at the time of sale, the excess may be taxed at higher ordinary income rates under certain circumstances as opposed to capital gains rates. This is called Cancellation of Debt Income or CODI which must be included in a taxpayer’s gross income.  There are also tax considerations in connection with many loan workouts or restructurings.

Tax consequences may be summarized as follows:

Footnotes Recourse Debt Non-Recourse Debt

Ordinary sale                          1               Gain or loss                       Gain or loss

Loan balance reduction           2               CODI                                Basis reduction

Short sale                                3               CODI & gain or loss         Gain or loss

Deed-in-lieu of foreclosure     3              CODI & gain or loss           Gain or loss

Foreclosure                             3              CODI & gain or loss          Gain or loss

Footnotes

1. A voluntary sale triggers capital gains or losses.  These are short-term if the property is held for less than one year, and long term if held longer.  Capital gains occur when the selling price exceeds the taxpayers adjusted tax basis, and losses occur when the selling price is below the taxpayer’s adjusted tax basis.  The basis of property is usually its cost.  Cost is the amount paid in cash, debt obligations incurred in connection with the purchase, and/or other property or services given as part of the purchase consideration.  These amounts are then adjusted (reduced) by depreciation deductions a taxpayer has claimed or could have claimed on the property, and increased by the cost of certain improvements to the property.  If the taxpayer takes less depreciation by using one method than it could have under another method, basis must be decreased by the amount it could have taken under that method.  If the taxpayer did not take depreciation, basis must be reduced by the full amount of the depreciation that could have taken.  Additional details of what else can and cannot be included in basis are included in the Appendix.

1. Recourse debt is debt that has been personally guaranteed by a taxpayer.  Any debt write-down of recourse debt triggers CODI or “Cancellation of Debt Income.”  CODI is taxed in the year debt is forgiven at ordinary income rates.  Write-downs of non-recourse debt merely reduces a taxpayer’s adjusted tax basis in the asset.

1. Short sales, deeds-in-lieu of foreclosures are considered “forced sales” and will result in tax consequences.

If the debt is recourse, the difference between the loan balance and the fair market value is calculated at ordinary income rates, and the remaining difference between the taxpayer’s adjusted tax basis and fair market value is taxed at capital gains rates.  An example follows:

Loan balance               $1,000

Difference is ordinary income of   $400

Fair market value       $600

Difference is capital gains of  $200

Adjusted basis      $400

If the debt is non-recourse, the difference between the loan balance and the taxpayer’s adjusted tax basis is taxed at capital gains rates.  In the case of non-recourse financing, the fair market value of the property is treated as not less than the outstanding debt balance.

Note that in many cases non-recourse debt may be converted to recourse as a result of various provisions in the loan documents.  These are often referred to as “bad boy carve outs” loan provisions. Examples might include the borrowing entity filing bankruptcy.  In such a case, a named individual would then become personally liable for the entire loan balance.  If more than one individual is named, each individual could in theory be liable for the entire balance.

1. If the property has a value lower than its basis, then in the case of recourse debt a taxpayer could get a capital loss and CODI or ordinary income on the same transaction. The taxpayer would not only be burdened with ordinary income rates rather than potentially capital gains rates, but it may have more total income to report, offset only by a capital loss that would be unusable except to a nominal extent in the case of individuals if the taxpayer had no other capital transactions for the year.  Only in the case of a taxpayer able to utilize one of the CODI exclusions, such as insolvency, could this result be better.

An example follows:

Loan balance               $1,000——————–

Adjusted basis                             400

The total difference of
$800 is ordinary income

The difference between basis and
fair market value of $200 is capital loss

Fair market value             200——————–

1. In all cases, recaptured depreciation (previously taken depreciation deductions) is currently taxed at 25%.

1. Exceptions to recognition of CODI include:
   1. If the discharge of indebtedness occurs in a Chapter 11 bankruptcy case;
   2. If it occurs when the taxpayer is insolvent; however, the tax is merely deferred to a time when the taxpayer is able to pay.[1]
   3. If the discharged debt is qualified farm indebtedness; or
   4. If the discharged debt is qualified real property business indebtedness.[2]

Note:  If CODI is excluded from gross income, a taxpayer’s tax attributes such as net operating loss carryover, minimum tax credit, net capital loss, or capital loss carryover must be reduced in the same year.  A taxpayer may elect to apply the tax attribute reduction first against the basis of the depreciable property of the taxpayer, not to exceed the aggregate adjusted basis of the depreciable property held by the taxpayer as of the beginning of the taxable year following the taxable year of the discharge.

State vs. Federal Law Regarding Deficiency Balances

Difference states have different laws regarding the ability of a lender to collect a “deficiency balance” – that is the difference between the unpaid balance of a loan and what it receives from the sale of its collateral.  Collectability of deficiency balances will not affect the calculation of gain or loss for federal income tax purposes.  However, any additional payment will reduce the outstanding loan balance and, thus, change the amount of federal taxes due, if any.

APPENDIX

Adjusted Cost Basis

The basis of property is usually its cost.  The cost is the amount paid in cash, debt obligations incurred in connection with the purchase, and other property or services given as part of the purchase consideration. Cost also includes amounts paid for the following:

1. Sales tax
2. Excise taxes

1. Abstract fees
2. Revenue stamps
3. Recording fees
4. Transfer taxes
5. Legal and accounting fees (when they must be capitalized)
6. Real estate taxes if assumed for the seller. They cannot be deducted as taxes paid in the current year.  If taxes paid by the seller are reimbursed by the buyer, these can usually be deducted as an expense in the year of purchase; do not include this amount in the basis of the property.  If these are not reimbursed to the seller, the basis must be reduced by the amount of those taxes.
7. Charges for installing utility services
8. Surveys
9. Owner’s title insurance
10. Any other amounts the seller owes that the buyer agrees to pay, such as back interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
11. Settlement costs do not include amounts placed in escrow for the future payment of items such as taxes and insurance.

The following are items that cannot be included in basis:

1. Fire and casualty insurance premiums
2. Rent for occupancy of the property before closing
3. Charges for utilities or other services related to occupancy of the property before closing
4. Charges connected with getting a loan.  For example:
   1. Points (these are deductible over the term of the loan) (special rules apply to residential property)
   2. Mortgage insurance premiums
   3. Loan assumption fees
   4. Cost of a credit report
   5. Fees for an appraisal required by a lender
   6. Fees for refinancing a mortgage

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[1] A taxpayer is insolvent when their total liabilities exceed the fair market value of assets.  For example, if a taxpayer has $100,000 in liabilities, but only $50,000 in assets, they are considered insolvent.  There a cancellation of a $20,000 debt will not need to be reported as gross income.  However, if a debt of $60,000 is cancelled, the taxpayer will have $10,000 in gross income because their total liabilities no longer exceed their total assets (cancelling $60,000 in debt means the taxpayer now has only $40,000 in liabilities).

[2] A qualified real property business debt is debt which (1) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property; (2) was either incurred or assumed prior to 1/1/93 or was incurred or assumed to acquire construct, reconstruct or substantially improve the real property; and (3) the taxpayer elects to apply this exception.