Pitfalls and opportunities in distressed real estate investing

KEY TAKEAWAYS

• 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.

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.”

Tipping point: 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.