News & Press

As published by Long Island Business News

A common real estate strategy being tossed around, somewhat loosely, is that landlords with struggling properties, particularly office, should just “give back the keys” to the banks.

U.S. tax laws are generally favorable for real estate, facilitating many landlords to defer tax bills until they sell their property. However, if the building’s value has declined when you attempt to ‘give back the keys,’ you may find yourself on the hook to the IRS with an unexpected tax bill.

This is due to the write-off from relinquishing your asset—it may be considered income, because you are effectively removing debt from your bottom line

Sales losses can be reported as income

Let’s consider the scenario of selling a struggling asset at a discount. For example, imagine you own a commercial building that you purchased for $30 million with $24 million in debt and $6 million of equity. If you sell the property for $25 million, you can pay off the original $24 million in debt and $1 million in equity.

This strategy leaves the equity investors with a $5 million tax loss because the bank needs to be repaid before the equity investors.

Now reimagine that scenario to include $10 million in asset depreciation taken since the purchase, such that the $30 million property is now only worth $20 million at the time of sale. You are thus left with a shortfall—not enough money to fully pay off the debt.

Under this scenario, with the property sold at just $20 million but with $24 million from the original debt, you now have a potential pickup of $4 million of “cancellation of debt income,” which is recorded as actual income. In may seem counterintuitive, but in certain situations, that will mean you, the seller, will have to pay taxes on that income, even though you sold the property at a loss. In this case, $4 million.

According to the IRS, “If your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable,” with certain exceptions. “If taxable, you must report the canceled debt on your tax return for the year in which the cancellation occurred.”

Full financial history

So what’s the best strategy for dealing with a troubled asset? The key is to consider the losses and gains associated with the investment over the complete history of the ownership or investment.

Many investors assume that selling a property at a significant loss means they can report that sale as a loss. However, given the structure of the tax code, that sale—even at a steeply discounted price—might turn out to be reported as income. For some owners, it can come as a shock.

When considering the sale of a property at what seems like a loss in the current market, it’s important to remember that determining losses and gains might be more complex than it initially appears, and that the only way to know for certain which side of the ledger you end up is to examine your complete financial history associated with the property.

Several factors can shift the outcome from losses to gains and vice versa, such as capital improvements during the ownership lifecycle (how much additional money you put into the property) and equity withdrawals (how much money you took out), among others.

Given these factors, you may find yourself deciding to retain your property after all. Then again, even with the unexpected tax burden, you still may determine that unloading the property is the better option.

There is no such “one-size-fits-all” strategy. Every asset and ownership situation is unique.

To avoid these potential tax problems with struggling commercial assets, many banks are crossing their fingers and hoping the real estate market will recover before the property debt comes due, the classic ‘extend and pretend.’ Part of the reason some banks are willing to ‘pretend’ is they have not yet marked their losses down to realistic levels given the conditions of the current market.

Dealing with a troubled real estate asset is far more complex than you might initially think. Before you pull the trigger on a sale—or give back the keys—we strongly suggest you do a financial review of the property’s history. That will be your guide as to the best strategy moving forward.

Rob Gilman is a partner and leader of the Real Estate group at Anchin, an accounting and advisory firm with offices in Melville, New York City and Florida.