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 Friendly Foreclosure

Print Me!
 
Russell J. Gullo - CCIM, CEA, of Buffalo, New York. Certified Exchange Advisor, President of R.J. Gullo & Co., a national qualified intermediary company for real estate exchanges, Director of Operations for the American Institute of Real Estate. (716)992-2711.

 Exchanging To The Rescue
Many real estate investors are faced with one of the worst possible nightmares: The loss of their property due to foreclosure. Not only do they lose the property, but it gets worse. There can be a large taxable gain (profit) because of the depreciation expense which has been providing a tax shelter each year that the property has been held in ownership. The beauty of depreciation expense is that it's a bookkeeping entry (paper loss) that allows the owner to shelter earned income. The bad thing about depreciation expense is that at time of disposition when we calculate gain (profit) all the depreciation expense taken is recaptured meaning it becomes taxable and is not taxed at the favorable capital gains rate.

 "...don't forget about Uncle Sam"
Most real estate investors don't realize even though they deed their property over to the mortgagee (lender) through what we refer to as a "Friendly Foreclosure", they can still face a serous tax problem.

The Problem

The following is an example of using a "Friendly Foreclosure" (deed in lieu of foreclosure) with nonrecourse debt. Ms. Velvet bought an apartment building in 1983. She paid $200,000 for the subject property, put $50,000 down and financed the balance.

It's now year 2001 and Ms. Velvet is experiencing a negative cash flow in her apartment building due to poor local market conditions. She has an adjusted basis in the property of $20,000 and an existing nonrecourse (mortgage) of $140,000. The reason for this outstanding debt of $140,000, is because Ms. Velvet was able to refinance her existing mortgage.

She is at the point where she has no desire to continue to feed this "alligator" and would like to investigate her options. Although the mortgage is nonrecourse, if Ms. Velvet were to deed in lieu of foreclosure the property back to the lender, financially speaking Ms. Velvet turns the keys over and walks away from a property that today, has been appraised at $100,000 with a $140,000 mortgage against it.

 ...what out for "phantom income" gain!
To most people this would be the thing to do. But don't forget about Uncle Sam. Although from the lender's point of view, Ms. Velvet handed the keys over to the lender who took back the property that she purchased for $200,000 when market conditions were better in her marketplace, this is the same property that has been appraised for $100,000 in today's market with a $140,000 nonrecourse mortgage against it.

Thus, Ms. Velvet is faced with another problem, what's called "phantom income" gain (profit) of $120,000 ($140,000 in nonrecourse debt less the adjusted basis of $20,000).

When a nonrecourse mortgage is deeded back in a foreclosure transaction, the fair market value of the subject property does not affect the tax consequences of the transaction.

The deemed sale (disposition) is based on the mortgage balance and the adjusted basis of the property. This would mean that Ms. Velvet would have a tax liability of about $38,000 based on the federal tax rate of 25% for recapture of depreciation not the favorable capital gains rate of 20% and the 7% for New York state.

That's right! You give up your property and it still costs you about $38,000 in taxes.

 ...the solution
By deeding the property over to the lender in lieu of foreclosure and structuring the transaction as a deferred exchange, Ms. Velvet can defer indefinitely the $38,000 tax liability.

This means that Ms. Velvet would take the $38,000 to acquire other business or investment held property of her choice in Anywhere, USA. She has the opportunity to acquire property in a different community with better economic conditions. How is this possible?

A foreclosure is looked at as a form of disposition which starts the clock for a deferred exchange transaction when title is conveyed back to the lender. Ms. Velvet must structure her transaction as a deferred exchange in order to receive these benefits. That means Ms. Velvet must bring into her transaction a professional Qualified Intermediary who is in the business of structuring deferred exchange transactions. Once the Qualified Intermediary has been assigned the rights fo the contract of the relinquished property and all the necessary exchange documents are in place such as the exchange agreement, qualified intermediary agreement and assignments, then title can be conveyed back to the lender. Ms. Velvet then has 45 days to identify the replacement property and 180 days to acquire legal title to the replacement property.

Ms. Velvet must use all her net proceeds from disposition and acquire another property deemed of a like-kind (in our example there is no net proceeds). So Ms. Velvet must go back into a replacement property that has at least the same amount of debt (mortgage) that she's giving up meaning $140,000.

 "...she gave up her property and still owes $38,000"!
You may be saying to yourself, Ms. Velvet is coming out of one nightmare and going back into another by using 100% financing. That is not what we are proposing. Ms. Velvet would have to come up with $38,000 to pay taxes if she did not structure here transaction as an exchange but just did the deeding in lieu of foreclosure. We know that she needs to acquire a replacement property worth at least $140,000, the amount of the mortgage. If she performs an exchange transaction she can actually acquire a property for as little as $102,000 if she wants, because she can offset the mortgage boot problem by adding $38,000 cash. And, if she wants she can pick a property in a better marketplace or downsize the purchase price. This is possible through the use of the deferred exchange transaction.

Posted: 1/18/2001 12:20:20 PM

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