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Chicago Deferred Exchange Company

Case Study: Deed in Lieu

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.

Finding appropriate replacement property could prove challenging, but some “zero cash flow” options exist that might fit the bill.

It is a worthwhile exercise to consider the tax implications of a deed in lieu of foreclosure. A tax-deferred exchange can provide respite from a current (and often unanticipated) tax bill.