Define the Current Tax Profile of Your Investment
When a TIC deal is threatened with foreclosure, many investors believe they will simply lose their equity and report a loss for tax purposes. However, in almost every case, this will not be true. For tax purposes, you will be treated as if you sold your interest in the property for your pro-rata share of the non-recourse debt, and a taxable gain will result if the value of the debt exceeds the adjusted tax basis of the property. Calculating the adjusted tax basis is not easy, but if you're like most investors in this situation, you probably acquired your TIC interest as a replacement property in a 1031 exchange, using non-recourse debt. If so, your adjusted tax basis would be determined at least in part based on the adjusted tax basis in the property that you sold into the 1031 exchange. Furthermore, you probably traded up in value on your 1031 exchange, so you may have added to your adjusted tax basis.
Before making any decisions, consult your accountant and make sure you know what your adjusted tax basis is. If your adjusted tax basis would result in a gain, then you will suffer the double indignity of losing your investment and paying taxes - the very thing you were trying to avoid in the first place.
If You Have a Gain, You Can Set up a New 1031 Exchange to Avoid the TaxesNote: If you have recourse debt, which would be rare in most cases, the foreclosure would be treated as a sale of the real estate at fair market value ("FMV"), and the amount of the gain would be calculated on an articulated basis: One part of the gain would be equal to the difference between FMV and adjusted basis, and the second part of the gain would be equal to the amount of the debt relieved that exceeds the FMV. This would result in cancellation of debt ("COD") income, taxed at ordinary rates.
Like Kind Exchanges are governed by Section 1031 of the Federal Tax Code. IRC § 1031 states that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged for property of a like kind. The regulations which define the term "like kind real property" generally consider US real property to be of like kind to all other US real property. Significantly, there is no requirement in the Code or the Regulations that a taxpayer must have equity in the property being transferred for the exchange to be valid.
Consequently, if a foreclosure or deed in lieu of foreclosure is inevitable, it's possible to enter into a deferred exchange by transferring the distressed property to a qualified intermediary ("QI"). The QI would allow the lender to complete the foreclosure. The QI would obviously receive no proceeds from the "sale" and therefore not be required to spend any money on a replacement property.
How Much Equity Will You Need to Complete the Exhange?
In order to avoid the receipt of "boot", you'll need to replace the replace the property with new property that has an FMV equal or greater than your share of the foreclosed property, and debt equal to or greater than your share of the debt on the foreclosed property. Practically speaking, this means you will more than likely need to put new equity into the exchange in order to obtain a loan that meets this 1031 threshold. Obviously, if the new equity required exceeds your tax liability, then a deferred exchange may not be economically viable. In most cases, it will make sense to do the exchange. However, it's helpful to have an advisor who is an expert on commercial real estate, including commercial real estate finance, since the availability of debt will play a central role in determining the amount of equity you need and whether it makes sense to move forward.
How to Identify A Replacement Property For The Exchange
If the amount of equity you need is less than your tax liability, now is the time to start thinking about value recovery. At this point, your choice of advisor is absolutely critical, because TIC sponsors and managers are not all the same. Your chances of value recovery will increase exponentially if you work with a firm whose interests are closely aligned with yours. This means the sponsor earns the vast majority of its compensation at the end of the transaction and ONLY IF the investment succeeds. Fees should be low, and they should definitely not deliver a 7 figure payday just for closing a deal. If your TIC sponsor does well only if you do well, you will have a much better chance at turning your loss into a real taxable gain.