How to Defer Capital Gains Tax Liability on a Commercial Foreclosure

By James Brennan, Principal/Corporate Counsel, Exchange Solutions Group

Unsuspecting commercial investors are driving to the bank to turn in their keys on projects that did not work out as planned, and they're waking up the following year with an unexpected tax headache. Find out how to get around the problem.

By James Brennan,
Principal/Corporate Counsel, Exchange Solutions Group

Unsuspecting commercial investors are driving to the bank to turn in their keys on projects that did not work out as planned, and they’re waking up the following year with an unexpected tax headache, because the discharge of the loan can result in a capital-gains-tax liability. Not only did the clients lose whatever equity they had in the property, but they also face capital-gains-tax liability for simply how they transferred the property to the bank!

Individuals confuse the property’s tax impacts with the property’s economics. However, these two calculations are different. For tax purposes, gain or loss equals the difference between the transfer price to the bank and the adjusted basis. Thus, if you bought a property in 1987 for $700,000 (your cost basis), and it has been depreciated and now has an adjusted basis of $400,000 and is foreclosed with a $950,000 loan, this transfer without a 1031 exchange results in a taxable gain of $550,000, i.e., $950,000 transfer price minus the $400,000 adjusted basis.

Drilling down, the amount of gain for tax purposes depends on whether or not the debt is recourse or nonrecourse. With nonrecourse debt, the taxpayer is charged with gain equal to the difference between the outstanding mortgage amount and the adjusted basis. Thus, the taxable gain equals loan amount, minus adjusted basis. To clarify, for nonrecourse debt fair market value of the property is not taken into consideration. In Commissioner v. Tufts, the Court pointed out that taxpayers receive value when they are relieved of a nonrecourse debt obligation.

For this problem, there is a solution. Exchange Solutions Group designs solutions for property owners facing foreclosure and related imputed gains. By purchasing another property of equal or greater value to the transfer price on the foreclosed property, a like-kind exchange can be used to delay the capital gain. The cash that would have been used to pay the tax liability can alternatively be redeployed into an asset rather than simply used to pay an expense.

To execute this strategy, all 1031 exchange procedures need to be followed. You must prepare exchange agreements, identify replacement property or properties and close within 180 days. Recall, that even if you are unsuccessful and end up with a “failed exchange” in the next year, you can elect installment-sale treatment and push the tax liability to the following tax year, if you structured this as part of a 1031 exchange.