A Solution for Troubled 1031 Owners

Before the Great Recession, many borrowers took out non-recourse CMBS loans. Then, when the economy tanked, they were forced to hand the keys back to the lender.

Even though the borrowers were handing over the asset, a taxable event was still being created. If a borrower with non-recourse loan hands a building back and $10 million in debt is forgiven, that is considered a gain by the Internal Revenue Service.

“You no longer have the building and you’ve received no cash in the sale,” says Avison Young Senior Vice President Rich Murphy. “But you’ve got a $10 million gain and you have to pay the tax on that gain.”

But there is a solution. “A 1031 exchange gets you over that gain the same way it would in any other scenario,” Murphy says. “The only difference here is that you don’t have any money with which to buy the replacement property.”

But a borrower can get past that with a zero-cash flow deal. In these structures, the rent the buyer receives is equal to what it will pay on its mortgage. These highly leveraged transactions work because the rent payment covers the debt and the borrower needs very little out-of-pocket cash. The structure only works if the tenant has strong credit and is on a long-term lease, which allows the buyer to put maximum leverage on the property. 

“The reason why zero cash flows can be a good plugin is that they offer about the lowest amount of cash outlay that you can make to buy a replacement property,” Murphy says. “They’re like 90% LTV loans or 80% LTV loans. You’re trying to buy something that’s very, very highly levered because you don’t have a lot of money with which to do it.”

While there were a number of problems with non-recourse CMBS loans during The Great Recession, it hasn’t been a huge problem yet during the COVID-19 crisis. But Jonathan Hipp, head of the US Net Lease Group at Avison Young, recently received a couple of calls from investors who have had to hand over their assets.

“It certainly seems to reason that this type of a scenario is going to play itself out more and more increasingly, particularly for retail properties—strip centers and things like that,” Murphy says.

Murphy says similar issues could also pop up with hotels and office buildings. “It won’t be all asset classes,” he says. “Surely it won’t be industrial, but there will be some asset classes where it’s going to happen.”

While there may be a limited number of these issues, owners giving back their properties is still worth tracking. “It’s going to happen,” Murphy says. “It’s just a question of how many.”