Workout-Driven Exchanges

Size: px

Start display at page:

Download "Workout-Driven Exchanges"

Lynette Lloyd
5 years ago
Views:

1 Workout-Driven Exchanges Todd D. Keator March 2, 2011

2 Recourse Debt Nonrecourse Debt Writedown/ Writeoff Discharge of indebtedness income Ordinary income Possibly excluded from income: If taxpayer is insolvent or in bankruptcy If the debt is qualified farm indebtedness If the debt is qualified real property business indebtedness If the debt is qualified principal residence indebtedness New law (IRC 108(i)) allows taxpayers to elect to defer discharge of indebtedness income and recognize it ratably from Discharge of indebtedness income Ordinary income Possibly excluded from income: If taxpayer is insolvent or in bankruptcy If the debt is qualified farm indebtedness If the debt is qualified real property business indebtedness If the debt is qualified principal residence indebtedness New law (IRC 108(i)) allows taxpayers to elect to defer discharge of indebtedness income and recognize it ratably from Foreclosure Debtor is treated as selling the collateral to the lender for the principal balance of the debt Deemed sales price is capped at the fair market value of the collateral The gain from the deemed sale generally is capital gain Any excess debt over the fair market value of the property produces discharge of indebtedness income This income is ordinary income and is eligible for exclusion or deferral (but not 1031) Debtor is treated as selling the collateral to the lender for the principal balance of the debt There is no cap on the deemed sales price The resulting gain generally is capital gain The exclusion and deferral provisions are unavailable for this type of gain Eligible for 1031

3 A QI: Enters into a written agreement with the taxpayer (the exchange agreement ) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. Regardless of whether an intermediary acquires and transfers property under general tax principals, solely for purposes of [this provision] (A) An intermediary is treated as acquiring and transferring property if the intermediary acquires and transfers legal title to that property, (B) An intermediary is treated as acquiring and transferring the relinquished property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person, and

4 Solely for purposes of [these paragraphs], an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.

5 Forward Exchange TP owns Blackacre and desires to acquire Whiteacre from Sarah Seller. However, Sarah Seller wants to sell Whiteacre for cash, not Blackacre. Bill Buyer, however, desires to acquire Blackacre, and is willing to pay cash for it. TP engages QI to facilitate the transaction as follows: Day 1: TP transfers Blackacre to QI, and QI sells Blackacre to Bill Buyer for cash. Day 2: QI uses the cash to purchase Whiteacre from Sarah Seller. Day 3: QI transfers Whiteacre to TP to complete TP s 1031 exchange.

6 Forward Exchange Example PSA TP Blackacre (6) Whiteacre (1) Blackacre QI Seller - Whiteacre Direct Deed (5) Whiteacre (4) $ (3) $ (2) Blackacre Buyer - $ Direct Deed PSA

7 Workout-Driven Exchanges - Example TP s property: Original price = $150 Held for investment/trade or business FMV = $50 AB = $20 Nonrecourse debt = $100 Lender threatening to foreclose. If no 1031 exchange: TP has gain of $80 (Tufts) Minimum tax (assuming no recapture) = $12; possibly as high as $20 if all 1250 gain taxed at 25%. Can 1031 apply? Probably yes. No requirement that QI hold cash or property Deed-in-lieu agreement may be assigned to QI TP must assume $100 of debt on replacement property, or pay cash of $100, or some combination, in order to avoid boot gain; RPP will require substantial down payment, but this can be funded with foregone tax (e.g., $20 down and $80 new debt)

8 Workout-Driven Exchanges - Issues If lender will not accept a deed-in-lieu, can TP still do a 1031 exchange? The problem is that there is no agreement to be assigned to the QI. Potential Solutions: Deed property to QI prior to judicial or nonjudicial foreclosure. Problems: Can TP find a QI willing to take title to foreclosure property? Does QI satisfy 1031 regulations requirement that QI must transfer the relinquished property to the buyer if the sheriff or trustee signs the deed and makes the conveyance? Create Agreement to Foreclose? Any substance? Assign rights under Deed of Trust to QI? If recourse debt, part may be COI income In prior example, $30 would be gain from sale, and $50 would be COI income (ineligible for 1031).

9 Workout-Driven Exchanges Issues Better to have lender consent. Deed in lieu Agreement to Foreclose Issues without lender consent: Is deemed transfer to QI a breach of the loan documents? Could 1031 exchange trip the recourse carveouts? Does the Exchange Agreement become part of the lender s collateral? Could replacement property become part of lender s collateral? Could lender write-down the debt prior to foreclosure, creating COI income for debtor? Can TP locate highly-leveraged replacement property? Can TP acquire underwater replacement property?

Workout-Driven Exchanges

Brooklyn Law School From the SelectedWorks of Bradley T. Borden February 4, 2009 Workout-Driven Exchanges Brad Borden Todd D. Keator Available at: https://works.bepress.com/brad_borden/24/ Workout-Driven