Considering tax implications of a deed in lieu

After the 2008 financial crisis, many real estate investors found themselves “underwater” on their properties: the debt on the properties exceeded the current fair market value of the properties. Many investors ended up turning their properties over to their lenders in lieu of a foreclosure, or simply going through the foreclosure process.

Aside from being separated from their capital and their property, when an investor turns property over to the lender in lieu of a foreclosure, the tax implications can be surprising.

The transfer of encumbered property to the lender is treated as a sale that is subject to gain or loss under IRC Section 1001. If the debt is non-recourse (as many loans were), then the entire amount of the debt is used when calculating the “amount realized” from the transfer – even if the debt exceeds the current fair market value of the property.

Consider the following example:

• Investor owns property with FMV: $6 million
• Current non-recourse mortgage debt: $8 million
• Adjusted basis of the property: $3 million

When the property is returned to the lender, the investor is deemed to have “sold” the property for the current outstanding debt amount: $ 8 million. With a $3 million basis, the investor has realized gain of $5 million and a potential tax liability (assuming a blended rate of 23%) of $1.15 million.

An IRC Section 1031 tax-deferred exchange can ameliorate this situation. The investor will need limited lender cooperation and will also need to identify and acquire replacement property within the prescribed time frames.