2009 Commercial Real Estate Trends

2009 Commercial Real Estate Trends: Taking Advantage of Opportunities and Avoiding Tax Traps in Today’s Distressed Real Estate Markets

2009 Trends in the CRE Market Place

The federal government has infused unprecedented massive amounts of money into financial markets nationwide, yet the credit crunch continues; and when lenders are loaning money the new loan rates are higher and loan to value ratios are lower. The same lenders are looking for a Debt Coverage Ratio that is above 1.2 and often in the 1.25-1.35 + range. Lenders are also looking at higher cap rates for determining value.

Sale-Leaseback transactions are increasing as businesses seek alternative sources of working capital from existing real estate assets.

Due to higher priced oil and future projected consumption, the energy sector is becoming more popular as an investment. Adding to that is the ensuing need to become energy independent and therefore solar farms, wind power and other alternative energy are gaining favor with investors.

“Green” initiatives are being aggressively pursued due to decreasing construction costs and the ROI on sustainability due to operating efficiencies and tenant demand.

In the commercial real estate market many investors are under water due to note balances that are in excess of Fair Market Value and/or not being able to pay the note balance on the due date (with many coming due in 2009-2010).

Ominous Tax Consequences Looming for Commercial Borrowers with Non-Performing Debt

Loan balances that are in excess of fair market value of the property could inflict onerous taxable events upon unsuspecting investors if there is COD (cancellation of recourse debt and/or deeding-in lieu or actual foreclosure by the lender (recourse and/or non-recourse debt in excess of the adjusted basis on the property) triggering capital gain tax recognition; resulting in investors having little or no cash to pay the debt or the tax liabilities.
With recourse debt; there are two types of tax liabilities that are created where the investors will recognize capital gain (or loss); the difference between the fair market value of the property (immediately prior to the disposition) and the property’s adjusted basis (purchase price plus capital improvements less depreciation). Many investors believe they have a loss, when in fact they may have a huge capital gain (especially a BIG (built in gain from a previous tax deferred exchange). In addition to the capital gains tax consequences, cancellation of debt (COD) triggers recognized ordinary income to the extent of the deficiency when fair market value is less than recourse liability, unless excepted (proof of insolvency, bankruptcy, etc.).

THE AMERICAN RECOVERY AND REINVESTMENT ACT OF 2009 – STIMULUS AND TAXES

For tax purposes, the cancellation of debt is taxable income in the year cancelled. The Act provides that for debt discharges in 2009 and 2010, a taxpayer can elect to have the debt discharge income included in gross income ratably over 5 years, starting in the fifth tax year (fourth tax year if the discharge occurs in 2010) after the year of discharge. Unfortunately, at this point in time, this election is not available to real estate investors. Therefore, the COD will remain as ordinary taxable income in the year the debt is discharged.

Following are examples of the onerous tax consequences that can occur from foreclosure, deed-in-lieu, and “workouts” that discharge recourse debt:

Calculation of Adjusted Basis & Debt:

Original Purchase Price (Original Basis includes $300,000 Land) $2,200,000
Depreciation Basis $1,900,000
Less: Depreciation $600,000
Adjusted Basis (includes land) $1,600,000

Calculation of COD Recognized Ordinary Income:

Amount of Loan Outstanding $2,000,000
Fair Market Value (Mark to Market) $1,800,000
equals COD “Ordinary” Income $200,000

Calculation of Recognized Capital Gain Income:

Fair Market Value $1,800,000
minus Net Adjusted Basis $1,600,000
Additional Capital Gain Income $200,000

Total Recognized Income: Ordinary & Capital
Gain Income $400,000

Note1): the “Ordinary” Income Tax on the $200,000 created by the COD could be as much as $80,000 + (35% Federal + 6% GA state tax (each state tax is different)) There could be more taxes if the additional ordinary income may eliminate the Alternative Minimum Tax exemption amount (another possible onerous tax consequence).

Note 2): (The Capital Gains Tax on depreciation is “Front Loaded”) 25% X $200,000 = $50,000 + 6.0 % GA state tax (each state is different) x $200,000 = $12,000. Total capital gains tax would be approximately $60,000 +. The total potential taxes would be $140,000 + (each state income tax will make a difference).

And, there could be even more taxes levied on the investors if the additional income eliminates the Alternative Minimum Tax (AMT) exemption amount and the Capital Gains Tax Preference items trigger Alternative Minimum Tax (another possible onerous tax consequence).

Non-Recourse Debt

And just when investors think it’s over, it’s not; if there is non-recourse debt on the distressed property, the investors will recognize capital gain income in an amount equal to the total debt secured by the property less the property’s adjusted basis.

Calculation of total Non-Recourse debt recognized as income $2,000,000
Less: adjusted basis $1,600,000
Recognized capital gain $400,000

Note 3: (The capital gain tax on depreciation is “Front Loaded”) 25% X $400,000 = $100,000 plus (Georgia state taxes) 6.0% x $400,000 = $24,000 The total taxes would be approximately $120,000 + (each state income tax will make a difference).

Unfortunately, many real estate investors are very much unaware of these onerous tax consequences; and by conveying title (deed-in- lieu or foreclosure) and/or debt discharge from “workouts” they could end up with tax bills and debt that they can’t pay.

There are Solutions available for Investors and Lenders

Now for some viable Win-Win solutions; Investors that are holding non-performing/under performing properties (or even performing properties) may be able to mitigate or eliminate onerous tax consequences due to COD and capital gain taxes (recourse and non-recourse debt) via strategies that may include “§1031 Workout Strategies”. The scenarios could include selling the property and exchanging it for a property of equal or greater value and equal (or greater) debt, thereby deferring the entire capital gain taxes. A partial exchange could also be an option with the results of deferring part of the capital gains taxes. Part or all of capital gains taxes deferred savings could be used to pay down the recourse debt and mitigate or eliminate the ordinary income recognition.

On the flip side the buyers of these distressed commercial real estate properties could be investors looking for opportunities to acquire valuable properties at discounts through a number of IRC §1031 strategies themselves. These §1031 Tax Deferral Strategies can be structured where the investors have properties scheduled for relinquishment but wish to wait for the market to stabilize in order to get the best price. Through an Exchange Accommodation Title Holder/Qualified Intermediary; the acquisition of the non-performing property direct from the current owner or the lender’s REOs and/or the notes portfolio now (and via the notes; the subsequent acquisition of the underlying properties) and afford themselves ample time (via a §1031 reverse exchange - Safe Harbor or non-Safe Harbor) to sell their scheduled relinquished properties.

If a buyer of the exchange property is short on capital, there are also §1031 Tax Deferred Exchange strategies utilizing creative "Seller Financing" options that can help the exchanging investors defer much or ALL of the capital gain taxes on the sale of the Relinquished Property.

All of the above strategies may very well create Win-Win Scenarios (for lenders, investors and borrowers alike). The lender is cashed out to the fullest extent possible, the investors own valuable properties at a discount to FMV and the distressed borrowers have mitigated onerous tax consequences. In addition, current commercial occupant(s) may have uninterrupted use of the property via leases negotiated i.e. lease payments vs. extensions or even Lease/Option to Buy?

There may be even Win-Wins in the residential sector where viable current residents remain in their homes? Could negotiations lead to the families paying less rent than previous mortgage payments with a lease/option to buy? The Big win? Neighborhood home values stabilize (due to fewer foreclosures which would depress the comparables even more).

Caveat:

Each individual investor, borrower and property situations should be analyzed by a team of skilled professionals. Each situation will fall under the “Snow Flake” theory. No two will be exactly alike.

Copyright William B. Hood, 2009

William B. Hood. CPA is the Southeast Division Manager with Asset Preservation, Inc. Bill is a graduate of Seton Hall University with a B.S. degree in Public Accounting. Bill is a Certified Public Accountant and is a member of the American Institute of Certified Public Accountants, Georgia Society of Certified Public Accountants, the Atlanta Commercial Board of Realtors and CREW.