If you (or your clients) have owned real estate for a long period of time, you are most likely faced with mortgage liabilities in excess of your adjusted tax basis in the real estate.1 Excessive depreciation deductions and mortgage refinancing have created what is commonly referred to as “phantom gain,” which is the excess of the mortgage liability over adjusted basis (also known as a “negative capital account”).2
If the value of the property has declined to a point where the mortgage is more than the property is worth and the property is potentially facing foreclosure, the real estate owner will soon learn that he/she will have to report and pay state and Federal income taxes on the entire phantom gain if a foreclosure sale occurs, even though there is no equity in the property.
For those who have this “phantom gain” exposure, but are not facing foreclosure, if they intend to sell the property for a small profit, the resulting state and Federal income taxes on that phantom gain may far exceed any cash netted from that sale.
A partnership owns a residential rental building. A 40% Partner’s allocable share of the building is as follows:
Adjusted Basis: $2,500,000
Gross Value: 10,500,000
The partnership decides to sell the building and distribute the cash to the partners. The 40% Partner will receive a distribution of $3,000,000 in cash.
The total gain allocated to the 40% Partner upon a sale of the building for its gross value would be $8,000,000 (Gross Value minus Adjusted Basis). The minimum gain (i.e. the “phantom gain,” as measured by the liability on the asset minus the adjusted basis) would be $5,000,000. Thus, Federal and state income taxes will have to be paid on the $5,000,000 tax gain.
Likewise, if the 40% Partner sells the partnership interest for its value, receiving $3,000,000 in cash, the entire $8,000,000 gain is reported immediately. The 40% Partner’s amount realized includes the mortgage encumbering the real estate, even though the Partner is not personally liable on the mortgage. The “phantom gain” is therefore $5,000,000.
If the $8,000,000 gain is taxable at a combined effective tax rate of approximately 35% (taking into account the 35% rate for the Section 1245 depreciation recapture, the 25% rate for Section 1250 depreciation, the 15% rate for the remainder of the capital gain, as well as the 10.5% California state income tax rate), the total income taxes on the $8,000,000 gain would be $2,800,000, leaving the Partner with only $200,000 after the payment of all Federal and state income taxes.
There is a technique approved by the IRS that can be used if the real estate is already owned by an entity treated as a partnership for Federal income tax purposes. If a foreclosure is anticipated, and the foreclosure proceedings have not yet begun, this technique can be used to shift the reporting of the phantom gain to a charitable remainder trust. Since the charitable remainder trust is tax-exempt, there will not be any income taxes on that gain. Alternatively, if a voluntary sale of the real estate is anticipated in the future, this technique can be used to defer the reporting of the phantom gain for up to 20 years. 3
The technique is designed to eliminate the excess of mortgage over basis by what is commonly referred to as borrowing basis from other assets. If the taxpayer has assets that he/she intends to hold for a long period, or assets that have significantly declined in value, the income tax basis in these assets can be shifted to the partnership that holds the phantom gain real estate. Using the situation described in the above example, the 40% Partner needs to borrow $5,000,000 of basis from other assets. The other assets are not limited to other real estate. Any kind of assets will suffice, even personal assets. For example, if the partner invested in the stock market and owns a portfolio of stocks with a tax cost of $5,000,000 and a value of only $1,000,000, these loss assets are ideal assets to use for the borrowing basis technique. In fact, any assets with a tax basis can be used, including personal assets such as a residence, an art collection or a life insurance policy.
If you or your client is facing this situation and would like to discuss the strategy to resolve this issue, please contact the author at (702) 341-6009 x1 or e-mail firstname.lastname@example.org.
1Taxpayers who have exchanged their real estate interests for interests in a REIT typically have this same exposure.
2Low adjusted basis can occur if the buildings have been fully depreciated, if accelerated depreciation deductions were generated from a cost segregation study, a refinancing occurred or a tax-free like-kind exchange took place.
3The technique can also be used for tax-free like-kind exchanges under § 1031 if the amount of mortgage financing for the property acquired is not sufficient.