When Commercial Real Estate Bargain Hunters May Become the “Prey”

Commercial real estate bargain hunters may become the “prey” due to “tax traps” in acquiring debt.

In today’s distressed Commercial Real Estate marketplace there are many opportunities for aggressive bargain hunting investors to acquire properties at a discount. They can execute the acquisition of the property direct from the distressed seller, from the lender as an REO acquisition and also acquire the note direct from the lender, as well, with one of the objectives of owning the underlying property through foreclosure or deed-in-lieu of foreclosure.

The investors are motivated to purchase notes at a discount from lenders that need cash or don’t want to add more REOs to their portfolios. The unwary or ill advised investors acquire the notes and could very well create tax nightmares as opposed to dreams coming true.

The culprit is “phantom income”. “Phantom income” is not a derivative of economic benefit, but it still exists. The most onerous issue when acquiring discounted debt is the creation of “phantom income” that is taxable with little or no cash to pay the taxes. As an example, a note is acquired from the lender by an investor for $1,000,000 (basis) and then forecloses on the underlying property that has a fair market value of $1, 300,000. The difference between the FMV of the property and the “basis” is $300,000 which creates recognized “phantom income”, which could be taxed as high as high as 35% for federal taxes plus the applicable state taxes.

The next example of taxable “phantom income” is when an investor acquires a note from the lender at a discount for $1,000,000 and the note’s fair market value is determined to be $1,500,000, the recognized “phantom income” is $500,000 which could be taxed as high as 35% for federal taxes plus the applicable state taxes.

We have not even taken into consideration the possible triggering of alternative minimum tax (AMT) from the taxable “phantom income” eliminating the AMT exemption amount and adding more to the investors’ tax bills, again, possibly with no cash to pay the tax! Ouch!

The tax accounting problems examples above regarding “phantom income” issues can be exacerbated and when “pools” of loans are acquired. Sorting out the “basis”, “fair market values” and the taxable “phantom income” in those pools can keep tax advisors working well late into the night.

Still, another example of taxable “phantom income” creation is through “significant” modification” to the notes by investors who modify the yields of the notes and or the term lengths, even adding guaranties or more collateral to non-recourse notes could very well be construed as a “significant modification”. And, depending on the new note holders’ activities – is the “phantom income” short capital gain or ordinary income? The best preventative solution, if possible, is to have the original lenders modify the notes prior to acquisition by the investors.

In conclusion, before investors dive into note acquisition bargain hunting, they should make certain that they have competent legal and tax council and understand the tax traps and risks that await them. We have only touched on just a few of the tax issues regarding debt acquisitions here. There are even more tax traps and risks that need to be understood or the bargain hunter investors could very well becoming the prey, with tax bills that they can’t pay.

Caveat Emptor!

My next post will include the acquisition of distressed properties, REOs and even the underlying properties of non-performing notes utilizing Section 1031 Tax Deferred Exchange strategies.

Copyright William B. Hood, 2009