1) 1031 Exchanges of Foreclosed Properties
Tax code §1031 provides generally that no gain is recognized on exchange of like kind business or investment property. However, taxpayers sometimes lose 1031-qualifying properties to foreclosure, a short sale, or a deed-in-lieu of foreclosure. Though the lost property might lack equity, disposition might trigger taxable gain.
How can there be gain? Consider the following: Purchased for $100,000 in 2000, a property ballooned to a $700,000 value in 2006 at which time the taxpayer took a $500,000 loan against it. When the foreclosure occurred in 2010, the lender reported the property was worth $320,000 and that the loan balance was $500,000. The taxpayer had taken $30,000 in depreciation from inception of the ownership of the property.
At the foreclosure, the taxpayer has a $250,000 tax gain ($320,000 value minus $100,000 original purchase price, plus $30,000 depreciation recapture). Under §1031, if the taxpayer buys another property worth $320,000, the tax on the $250,000 gain will be avoided. In order to obtain §1031 treatment, however, taxpayers must establish an exchange agreement with a “qualified intermediary” (also known as an exchange “accommodator”), bearing in mind the special challenges of the “sale” of the foreclosed relinquished property.
In this scenario, the taxpayer may buy the replacement property with no money down, with no loan, or part loan-part cash. To avoid tax on all the gain, the taxpayer must buy at a purchase price of $320,000 or more. The taxpayer may get partial relief – if the replacement property purchase price is less than $320,000. For example, a replacement property purchase price of $280,000 would result in taxable gain of $40,000 ($320,000 “price” of foreclosed property minus $280,000 purchase price of replacement property: the gain being net debt relief of $40,000 is commonly known as “boot”).
Under these facts, the taxpayer has $180,000 “cancellation of debt income” (“CODI”), either with or without the §1031 exchange ($180,000 CODI equals the $500,000 loan balance at foreclosure minus the $320,000 value). The CODI is in addition to the gain shown above; and, CODI is ordinary taxable income. Tax code §1031 does not shield CODI; tax code §108 provides that CODI is excluded from taxable income in certain situations (for example, debt canceled in bankruptcy is not taxable). However, a full discussion of §108 is beyond the scope of this article.
Additionally, if the taxpayer seeks a §1031 exchange upon foreclosure, a higher value of the foreclosed property will reduce CODI and will allow greater relief under §1031. For example, assume the same facts as above, except the foreclosed property was worth $420,000. If this was the case, then the CODI would be only $80,000 ($500,000 loan balance at foreclosure minus $420,000 value). If the taxpayer can reasonably demonstrate a higher value for the foreclosed property, he may get greater relief in a §1031 exchange (this is not an absolute rule; in some cases, a lower value might save more tax). Also, be aware that a Lender will likely issue an IRS Form 1099-C or 1099-A stating the foreclosed property’s value. The IRS form is not conclusive and a taxpayer does not have to use the 1099 value – if another value can be demonstrated, for example, by comparative sales.
Yet, with the taxpayer’s credit score being negatively affected by the foreclosure, one might ask how does the taxpayer qualify to buy a §1031 replacement property? In certain circumstances, the taxpayer might consider taking over another property subject to the existing loan (thus, there would be no qualifying). In this author’s opinion, there are plenty of pre-foreclosure properties available for a buyer. Additionally, a no-money-down purchase will meet the §1031 requirement, provided proper closing procedures occur.
2) Tax refunds from NOL Carrybacks
Many upper-income individuals used their home equity lines of credit to buy investment properties when values were escalating. These taxpayers sought to increase their wealth through their leverage. However, they were unable to reap the tax benefits of over-leveraged real estate due to tax code §469.
This section generally denies losses from rental real estate for taxpayers having adjusted gross income over $150,000. Such §469 losses are called “passive activity losses” or “PALs”. Thus, those taxpayers who accumulated significant negative cash flows on properties (in the quest for wealth through appreciation), but could not deduct those PALs currently against wages and other income. Under §469, the PALs are not lost forever, but rather, are merely suspended for future use upon sale of the property or net income or gain from similar properties.
PALs, however, are triggered upon a foreclosure of those investment properties. As a result, all of the suspended PALs from prior years are recognized against wages and other ordinary income in the year of the foreclosure(s). Triggered PALs and losses on foreclosure sometimes create a current year “net operating loss” (“NOL”), pursuant to tax code §172. A NOL is negative taxable income with some adjustments. A taxpayer may apply a NOL to a prior year. This is known as a “carryback”. The NOL carryback reduces income in a prior year as if the NOL occurred in that year. Under §172, a 2010 NOL is carried back to 2008. This means that the taxpayer can re-figure his 2008 tax return as if the 2010 NOL was a deduction on his 2008 tax return. Example: a taxpayer has 2010 NOL of $200,000; and had $200,000 taxable income in 2008 and paid $50,000 in federal income taxes. Then, the 2010 NOL is applied to 2008, and the taxpayer can get an immediate refund of the $50,000 taxes they paid in 2008. To get the refund, the taxpayer must file a claim (i.e., amended tax return) with IRS.
Additionally, NOLs exceeding a prior year’s income can be carried to other years. Example: taxpayer 2010 NOL of $200,000 is carried back to 2008. Only $150,000 of the NOL is absorbed in 2008, and the other $50,000 is applied to 2009. For NOLs occurring in 2008 and 2009, an election allowed carryback for up to five years. While federal tax law generally specifies a 2-year NOL carryback, the tax code allows an election to carry over NOL to future years without having to carry back. California does not permit NOL carrybacks,
but allows NOL carryovers.
3) Stiffing the Second
In situations of “negative-equity”, the second deed of trust lender faces poor remedies when the loan balances exceed the value of the property. If the borrower continues to pay the first loan, the taxes, and insurance, defaulting on the second loan may encourage a settlement with the second lender. Upon default, the second lender can either implement a non-judicial foreclosure or sue (judicial foreclosure). The non-judicial foreclosure leaves the second lender with the property subject to the first loan, and with no deficiency judgment by law (“one action” rule).
On the other hand, a judicial foreclosure may yield a deficiency judgment, but the lender may face court delays, attorney fees, borrower’s redemption rights, an uncertain deficiency sum, and potential borrower bankruptcy. These issues often discourage such action. Consider the following example a second lender may face: a property is worth $300,000, with a first loan balance of $280,000 and a second loan balance of $100,000. The deficiency is $80,000 (value minus combined loan balances). If the owner defaults on the second loan, the second lender might be smart to take the owner’s offer to pay $10,000 in full settlement instead of seeking its poor choice of foreclosure remedies.
After settlement, the second lender will issue IRS Form 1099-C reporting the canceled debt as income (“CODI”).
However, the debt forgiveness ($90,000 in the example) far outweighs income tax on the CODI. In addition, tax code §108 might exclude all or part of the CODI from taxable income. However, negotiating a settlement with an institutional second lender requires patience and hard work. Because laws vary by state, the lender may not understand its poor California remedies. A letter from counsel should explain the second lender’s poor remedy choices, with the offer to discount. Still, experience shows that the lender will not respond quickly or easily (if at all) to the offer. The lender will likely ask for financial information from the borrower. Resist the temptation! The lender could use the information later in a suit against the borrower if the plan goes awry. These are just a few of the challenges and opportunities in these times for clients and their counsel to identify and tackle.
- G. Scott Haislet, CPA, is a tax attorney (certified specialist) in Lafayette, with practice emphasis in real estate, 1031 exchanges, and IRS matters. Contact him at 925-283-1031 or firstname.lastname@example.org.
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