By: Bobbi Jo Lazarus, CPA, Elliott Davis

Recent changes with commercial lending requirements have driven some real estate investors to develop new approaches to investing in real estate. While these approaches may give way to significant earnings, investors should be aware of events that could also trigger phantom taxable income.

The continued increase of distressed loans on lenders’ balance sheets, matched with the increase in required equity and occupancy rates for traditional financing, some real estate investors have found that it is more beneficial to purchase these distressed loans directly from the bank at a significantly reduced price. While the reduced price can be very appealing, future transactions or modifications can lead to unforeseen taxable income.

One opportunity investors see in these investments is the option to acquire underlying real estate by foreclosing on the purchased debt. This deed-in-lieu transaction is deemed a sale for tax purposes. Proceeds become equal to the lesser of the fair market value at the time of foreclosure, or the amount of the secured debt. Investors can be caught off guard in this scenario, when there has been an increase in value of the underlying asset since the time the debt was originally purchased. It is important to note that the fair market value is determined at the date the deed-in-lieu takes place and not the date the debt was purchased. When an increase in value has occurred, the deemed purchase price becomes equal to the increased fair market value. Investors can find themselves with unexpected taxable income in the amount the value has increased from the original purchase of the debt. When presented with the option for a deed-in-lieu transaction, whether you are the lender or borrower, we recommend that you contact your tax advisor to discuss the tax implications as well as any alternative options.

While some investors purchase these bad debts with the intent of quickly entering into a deed-in-lieu transaction, others view it as a sound investment when performing debt can be purchased at a significant discount. Often these performing loans can be a good purchase. However, investors should be aware that modifications to the debt instrument can be considered an exchange of the original debt instrument for a new instrument, thereby resulting in income recognition for the difference between fair market value, or face value, of the deemed new debt and the lender’s basis in the original debt.

This recognition of income occurs, when there is a deemed significant modification of the debt. A modification is deemed significant if, based on all of the facts and circumstances, the alternation of the legal rights or obligations are economically significant. It is important to note, that when determining the level of significance, all modifications are considered collectively so that a series of modifications may be considered economically significant even if none would be considered significant on its own.

The IRS has issued guidance on when a change in the yield instrument, timing of payments, obligor, underlying security, or other modifications takes place. Included in this guidance is an explanation of the safe harbor rules that can protect the lender when there is a change in the timing of payment resulting from the deferral of one or more scheduled payments.

To illustrate the impact of these rules, assume that an investor purchases a note with a $35 million face value for $20 million (i.e. a $15 million discount). The investor then enters into various modifications of the note with the borrower, including extending the maturity of the debt, reducing the interest on the debt, as well as various other items. The face value of the debt remains unchanged. Also assuming that these modifications, whether as a whole or individually, are deemed significant based on their facts and circumstances, the investor would be considered to have exchanged the original note for a new note. This exchange would result in the recognition of $15 million of income, the difference between the $35 million face value of the deemed new loan and the $20 million basis (purchase price) in the original loan.

As the real estate industry changes, investors will continue to be challenged to find new and innovative ways to increase their rate of return. The opportunity to purchase existing debt at a discounted rate may prove to be an advantageous business plan for some investors. Before entering into a transaction of this type, or making changes to an existing transaction, consult your tax advisor to discuss the tax implications of phantom income that could be triggered without your knowledge.

About the Author:  Bobbi Jo Lazarus is a CPA focusing tax planning and compliance services specifically in the partnership, and individual income tax return reporting areas with a specialization in the real estate industry.  Elliott Davis is one of the largest accounting, tax and consulting services firms in the Southeast and ranks among the Top 50 CPA firms in the U.S.  Learn more at www.elliottdavis.com.