It is not a secret that many commercial real estate loans standon shaky foundations. In-fact it has been recently estimatedthat a “sizable amount of the additional $700 billion in commercialreal estate loans coming due during that time frame are loans thatcould not get refinanced at existing levels in the current lendingenvironment”. This of course will lead to many foreclosures andcreate an investment opportunity for CRE buyers. However, for theunfortunate holder of the original asset there may be a potentiallyhuge tax consequence. There may also be a glimmer of hope in theform of a Zero-transaction.

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Simply speaking a zero transaction is the acquisition of aproperty using a highly leveraged loan (loan to value usually 88%plus) with all rental income dedicated towards debt service, thusproducing “zero income” for the property owner. One of thevehicle’s applications is to defer tax liabilities incurred in acommercial foreclosure.

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The Problem

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Though it is not widely known, the foreclosure of a commercialproperty is often a taxable event. How the IRS computes the taxdepends on whether the property was financed with a recourse ornon-recourse loan. In the case of a recourse loan, tax liability iscalculated by taking the difference between a property’s fairmarket value and its adjusted basis. The tax liability of anon-recourse loan (which the remainder of this piece will bedealing with) is calculated by taking the difference between aproperty’s outstanding mortgage balance and the property’s adjustedtax basis.

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The “outstanding mortgage balance” is the key element whichcatches investors off guard.

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For example:

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Let’s say you bought a property for $5M (your cost basis) whichsubsequently has been depreciated to an adjusted tax basis of $3M.Let’s also say you refinanced this property during an upsurge inthe market and pulled out $8M of equity. If this transaction wasforeclosed upon (without any action to defer tax liabilities), youwould face a taxable gain of $5M, i.e. the $8M in outstandingmortgage amount minus the $3M in adjusted taxbasis.

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Thus, investors who think returning the keys to the bankabsolves them of all monetary concern involved in a commercialforeclosure are gravely mistaken. The IRS views any moneypreviously pulled from a property via loan refinancing to betaxable gain, even though the property is foreclosedupon.

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The Solution

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With proper scheduling and use of the 1031 exchange, thesituation above can be avoided through the purchase of a “zeroincome” property. The reason a zero income property can be sobeneficial is due to its highly leveraged nature and its ability todefer a taxable gain through a 1031 transaction. A portion of themoney an investor would have otherwise paid to the IRS can be usedinstead to acquire the zero income property through the 1031exchange.

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Here is how our previous example would be impacted by a zerotransaction:

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Assuming a tax rate of 25% (Federal capital gains rates, Federalrecapture rates and state taxes), the $5M in gain would cost $1.25Min taxes. If instead, a zero transaction was pursued, the investorwould need to replace the balance of the debt, $8M. By exchanginginto a zero income property for approximately 10% of the $8M debtamount replaced ($800,000), there would be a $450,000 savings($1.25M-$800,000) and the investor would own NNN property with avery high credit tenant.

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In order for the transaction to flow smoothly, it will have tobe properly organized and scheduled on an individual basis. Itshould be noted that a zero transaction is not possible withoutoutside assistance of at least a Qualified Intermediary andqualified professional tax and accounting advice. If done properly,this strategy can be an invaluable tool for investors caught in aforeclosure situation.

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Jonathan Hipp

Jonathan Hipp began his career in real estate over 25 years ago. In his early years as a broker, he ventured into the net lease industry and quickly began leading the US net lease market, closing over $3 billion in transactions. In 2005, Jon founded Calkain Companies, a company focused solely on net lease investment services. As President and CEO, he has been instrumental in building the firm into one of the leading Net Lease real estate companies, transacting over $12 billion of net lease deal volume over the past 13 years. He has expanded Calkain’s services to include brokerage, advisory, asset management, capital markets, and industry research. He has become a well-known resource, panelist, and speaker at various Net Lease and Industry conferences and is a regular contributor to GlobeSt.com on real estate trends. In June 2015, Jon’s passion for the real estate business was again recognized as he was nominated for the Top Real Estate Player in the DC area by SmartCEO magazine.