The prolonged real estate recession in various parts of the country has been devastating to many investors. Not only have high vacancies reduced income and limited rent increases, but lower property values have whittled away the equity in their properties. Many investors have considered simply walking away from their properties and allowing foreclosure to occur. 

            Unfortunately, foreclosure may solve one problem only to create another one. For, as bizarre as it may seem, an investor who has lost a property through foreclosure may now face a whopping tax bill as a result. This can occur because a taxpayer whose property is foreclosed upon is treated as having “received” cash in the amount of his or her debt relief. To the extent that the taxpayer’s debt relief exceeds his or her adjusted basis in the property, the taxpayer will have a taxable gain which must be reported in the year of the foreclosure. 

            Problem:  Mary Jones owns an office building with a $500,000 mortgage against it. Her adjusted basis is $200,000. She has tried to sell the building for two years but the highest offer has been $500,000. The building has a substantial negative cash flow. If she lets the building go in foreclosure, she will be treated as having a taxable gain of $300,000 (i.e., $500,000 - $200,000), reportable in the year in which the foreclosure occurs. 

            Obviously, a heavy tax burden in addition to the loss of the property is disastrous. Can this result be avoided if the investor transfer the property in a tax-deferred exchange rather than letting it be foreclosed upon? 

            Proposed Solution:  Mary Jones agrees to sell her office building to Bob Buyer for $500,000, who would pay nothing down for the property but would take “subject to” the $500,000 mortgage. The transaction would be structured as an exchange so that, at close of escrow, Mary Jones would transfer the property to the intermediary, which would immediately transfer it to Bob Buyer. Bob Buyer then could attempt to negotiate a restructuring of the loan with the lender. If he is successful, there would be no foreclosure. If he is unsuccessful, foreclosure would occur but Bob Buyer would not have lost any money in the transaction. Meanwhile, Mary Jones would complete her tax-deferred exchange by advancing to the intermediary the cash necessary to acquire the replacement property. If the transaction is treated as a fully tax-deferred exchange, Mary Jones would have no tax to pay, even though she was relieved of the $500,000 liability. 

            The big question is whether a “no equity” exchange is permissible. Surprisingly, there is no clear answer to this question. On one hand, the courts permit great flexibility in the structuring of exchanges, and there is no statutory requirement that a taxpayer have equity in the relinquished property. On the other hand, the IRS could argue that the property being exchanged is not being held, at the time of the exchange, either for “productive use in the trade or business” or for “investment.” Since property must be held for a proper purpose in order to be exchanged, holding property with the sole intention of unloading it might disqualify the exchange. 

            There are no regulations, revenue rulings or court cases directly on point. The Treasury Department has long considered issuing a ruling on this issue, but, apparently, has never been able to decide what position it should take. 

            If a “no equity” exchange is attempted, many issues need to be resolved. How can the investor convince a buyer to participate in such an exchange?  Should the lender participate in the transaction in any way? What sort of indemnities are needed? How can the investor avoid having the buyer treated as his or her agent? What role will be played by the intermediary? 

Copyright © 1994 Richard A. Goodman