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With tax day upon us and small glimmers of hope that the economy may soon be looking up, we'd like to remind our clients and business partners that a real estate sale in a down market may have unintended tax consequences.
 
Consider the following example:
 
In 2001, Drake purchased an industrial warehouse in West Dundee, Illinois for $15 million. At that time, Drake's lender was happy to extend him financing in the amount of $10 million and Drake contributed the remainder of the purchase price in cash.
 
In April of 2007, Drake decided to invest in a new real estate venture with his brother Donald and sought to refinance the West Dundee property in order to raise cash for the new investment.
 
In October of 2007, one of Drake's major tenants at his industrial warehouse terminated their lease and exited the Midwest market.
 
After struggling through year-end of 2007 and through the first quarter of 2008, and unable to replace his major tenant, Drake put his warehouse on the market hoping for a quick sale.
 
Drake listed the property for $18.75 million. His adjusted cost basis was $11 million and his tax-advisor recommended Drake consider a tax-deferred exchange under IRC Section 1031. Drake thought about putting more money into Donald's project but quickly decided against it after Donald encountered some issues with his lenders.
 
Several months passed and Drake was compelled to drop the price on his warehouse multiple times. Current market data indicated that local real estate prices declined between 15% and 20% in the last 12 months.
 
In November of 2008, Drake reluctantly accepted an offer of $14 million. His outstanding loan on the property as of closing was $14.25 million. Like many sellers in this market, Drake was forced to bring cash to closing in order to transfer clear title to his buyer.
 
Since Drake sold his property for an amount that was less than what he paid for it and he was "upside down" on his mortgage, he assumed he would not have any tax due when he closed so he did not consider whether a tax-deferred exchange was desirable or necessary.
 
Drake overlooked the impact the depreciation recapture rules will have on his tax situation. The recapture rules are designed to impose tax on the depreciation deductions taken by Drake during the eight years he owned his property.
 
While Drake has no appreciation in his property at the time of the sale which would be taxed at favorable capital gains rates, he is required to recapture and recognize the gain on the difference between his current sale price and his adjusted cost basis.  The depreciation recapture rate is currently 25%.  Sadly, unless Drake has operating losses to offset his recapture, he'll be forced to recognize gain and pay tax of $750,000.
 
If you have questions or would like to discuss further, please feel free to contact us at 866-677-1031.