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Developers and investors are accelerating the pace of note acquisitions, an already popular strategy for acquiring troubled real estate. With the continued weak economy, buyers have found it can be an effective tool for eventually acquiring property at dramatic discounts, and banks are tiring of holding troubled real estate. However, tax implications and other potential pitfalls can trip up unwary buyers.

In our work assisting investors through this and other market cycles, we’ve found the following to be helpful tips and tactics for effective note acquisition:

Befriend Your Banker—Any Bankers—with REO

Banks continue to be the leading source for troubled assets and note acquisition opportunities. For most banks, it’s outside their core strategy to hold real estate owned (REO) property that came into bank possession following a foreclosure. Selling real estate notes at a discount can be an attractive alternative to foreclosures altogether, given the hefty legal fees and government regulations they entail.

Analyze Tax Implications Thoroughly Beforehand

This is critical—but it can be complex. If a note purchaser ignores the distressed level of the debt, any interim payments received from the borrower on the note are treated as interest income for tax purposes. For example, if you acquire a $10 million note for $5 million, any payments on the note would be treated as interest income up to the $5 million discount. An alternative position, depending on the degree to which the debt is distressed, would be to treat the payments as a reduction in the principal balance of the note.

Buying Your Own Note? Note the Debt-Relief Income

Firms buying their own real estate notes for a discount can create another series of knotty tax issues. Let’s say a real estate firm acquires a property for $10 million, financed with $3 million in equity and a $7 million note. The property then drops in value, to $6 million. Using investor equity or an alternative source of capital, the firm offers to buy the bank out for $5.5 million.

The bank accepts this offer, because it doesn’t want to be exposed to further downside risk, deal with foreclosure, or carry any REO on its books. In addition, the bank gets a good chunk of its cash back, even though it takes a haircut on the note. The real estate firm benefits from the deal because it gets out from under $1.5 million in debt and continues to own the property, which it just effectively purchased at a $500,000 discount.

From a tax standpoint, however, this transaction creates cancellation-of-indebtedness income for the real estate firm to the tune of $1.5 million, the amount of debt relief, and not cash to pay the tax liability. If the firm does nothing, it will have to recognize the income. Fortunately there are restructuring options that could help it avoid recognizing the income and instead reduce the basis of this asset or another piece of real estate.

Foreclosure Bidding: Watch for “Paper” Gains

Another intricate tax twist often takes place when a real estate firm, after acquiring a note, initiates judicial foreclosure proceedings on the property in a state that requires a formal bidding process. Once the bidding is under way, the price of the property may be driven up by others competing for the real estate. If the winning bid exceeds the amount paid for the note, that triggers a gain for the firm. For example, if a real estate firm buys a property note for $5 million but the bidding pushes the property price and the firm’s winning bid up to $6 million, the firm has $1 million in taxable income on what’s essentially a paper transaction.

As these examples show, investors buying discounted real estate notes must tread carefully or potential returns can quickly slide away.

Greg Martin and Chris Paris provide strategic tax planning services—including 1031 exchanges, mergers, acquisitions, and entity selection—for commercial and residential developers, investors, and alternative investment funds. For more information, visit www.mossadams.com/realestate.