INSIGHTS AND RESOURCES
Pitfalls and opportunities in distressed real estate investing
INSIGHT ARTICLE |
Authored by RSM US LLP
- Investors who purchase distressed debt may trigger phantom income and significant tax exposure.
- Buyers can minimize tax exposure if they intend to acquire debt to ultimately obtain real estate that is secured by that debt, and they plan on repositioning or significantly improving their investment.
- Investors looking to purchase assets in Canada should understand local tax laws, including the lack of like-kind exchanges and a hefty provincial land transfer tax.
Buyers looking to purchase distressed debt need to think about more than just what they should be willing to pay. They also need to consider the tax implications, because a misstep could result in serious exposure.
If a buyer doesn’t pursue a debt workout with the borrower but holds the note to maturity, the market discount rules come into play which require the buyer to recognize ordinary income (rather than capital gain) related to the discount to face. In addition, if a buyer purchases nonperforming debt with the intention of pursuing a debt workout with the borrower, it could create so-called phantom income as it could be considered a significant modification of the original debt instrument.
“You have to be very careful when acquiring and modifying notes of distressed debt. We have seen issues among middle market firms who did not fully understand the tax ramifications. When decisions have to be made quickly, details can get lost.” — Marlon Fortineaux, RSM US Tax Partner
For example, a bank that wants to get a $100 million nonperforming debt off of its books may sell that debt to a buyer for $80 million. However, because the note is still at face value worth $100 million, the buyer will recognize $20 million in ordinary income if it ultimately receives the full face value of the note. Buyers can potentially trigger the same phantom income during negotiations with the original borrower if they make significant modifications to the terms of the existing note, so firms that want to hold onto debt should always consult a tax expert before making modifications to debt agreements.
A similar pitfall exists for buyers who intend to acquire distressed debt as a mechanism to acquire the underlying real estate securing the loan and the value of the property exceeds the amount paid for the debt. For example, if a buyer purchases a debt note worth $100 million for a property that is valued at $120 million, and then attempts to foreclose on the property, they may also see $20 million in phantom income.
There are many ways to mitigate both issues according to Marlon Fortineaux, a tax partner with RSM. In a distressed market it will not be difficult to reassess a building’s valuation to a lower number, given the distressed transactions happening in the marketplace. Investors may also be able to mitigate tax exposure if they plan on making significant improvements to the real estate and utilizing depreciation expense to shelter the phantom income.
“At the end of the day, tax law doesn’t always align to the economics of the real world,” Fortineaux said. “There’s always a solution to the problem; it’s just a question of bringing in a tax advisor to navigate the issues during the due diligence process.”
Though purchasing distressed debt and assets can require speed, investors need to slow down enough to get their arms around the potential tax ramifications of any acquisition.
Call us at +1 213.873.1700, email us at firstname.lastname@example.org or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by RSM US LLP and originally appeared on 2021-04-01.
2020 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Vasquez & Company LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Vasquez & Company LLP can assist you, please call +1 213.873.1700.
Subscribe to receive important updates from our Insights and Resources.