Tax Pros Take on the Challenge of Big Write-Downs on Troubled New York Properties

An office market in deep crisis has found many properties selling like this — that is, for a fraction of their previous values. Because of this, sellers are dealing with tax implications they may not be used to compared to selling properties at or close to expected value.

Given the multifaceted nature of real estate deals, every situation will have its own peculiarities. But talking with some of New York’s top tax accountants and attorneys reveals a byzantine system where apparent losses could turn into taxable gains come tax time. (The usual disclaimers apply: Nothing in this article should be construed as legal or financial advice — consult your people.)

These subverted expectations are aided in part by New York’s City’s unusual method for calculating property taxes.

“Everywhere else in the United States and possibly the free world, real property taxes are based upon the market value of real estate. But that’s not the case in New York City,” said Stuart Saft, partner at the law firm Holland & Knight. “The owners of commercial property submit income and expense statements for their building each year, and the tax assessor’s office calculates their opinion as to the taxes based upon the income and expenses — in a sense, what they think the profit on the building would be when capitalized.”

This subjectivity can leave portions of a seller’s tax bill at the whim of the city.

“If a building went for less than the initial sales price, then the real estate assessment should go down. But it doesn’t always happen precisely because the city will look at sales prices as part of its valuation, and the city’s going to be reluctant to lower the price,” said Jay Neveloff, partner and real estate chair at the law firm Kramer Levin. “The tax assessment of a building that’s sold for a loss commensurate with a reduction in value would mean the city’s going to lose more tax revenues.”

From these complex origins, there are numerous factors to account for when considering taxable scenarios.

Pamela Capps, a tax partner at Kramer Levin, lays out a scenario where a commercial building is purchased for $10 million. The buyer puts in $3 million in equity, borrows $7 million, and takes $8 million in depreciation over time. The buyer then sells the building for $8 million.

“I have a $10 million basis in the building because that’s what I paid for it,” said Capps. “I got to write off my initial $3 million, plus I took another $5 million in tax deductions and got the benefit of that. Now I have a negative basis in my partnership interest. So, even if I sell it at a lower price, I’m going to have a gain, because I’ve taken deductions with money I didn’t put in.

“You can only take tax losses per money that you put into the deal. That’s a common issue in real estate sales — because of depreciation deductions and debt on the property, you can wind up with negative basis that will result in a gain even if you sell at a lower price than you bought it for.”

Rob Gilman leads the real estate practice at accounting and advising firm Anchin. Gilman lays out the scenario of a commercial building purchased for $30 million with $24 million in debt and $6 million of equity, which is eventually sold for $25 million.

“You ended up paying the $24 million debt, and the equity investors have a $6 million tax loss,” said Gilman.

But now reimagine that scenario to include $10 million in depreciation taken since the purchase.

“The tax capital is now negative $4 million,” said Gilman. “I still have money to pay the debt, but now I have a recapture because I ended up taking more write-offs than what I put in. An investor is going to have a $4 million pickup of income.”

This will leave the seller with taxable income even though they’ve sold the property at a loss.

Then Gilman alters the scenario again, this time imagining the building sold for only $20 million, leaving the seller without enough money to fully pay the debt.

“Now you have a potential pickup of $4 million of cancellation of debt income,” said Gilman. “In certain situations, they’re going to have to pay taxes on that income.”

According to the IRS, “If your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable,” with certain exceptions. “If taxable, you must report the canceled debt on your tax return for the year in which the cancellation occurred.”

This is particularly notable for recourse debt, where the borrower is personally responsible for the debt.

“If you have a debt that’s recourse, you could end up with a loss on the property, but also have cancellation of indebtedness income if the value of the property is not enough to cover off the debt,” said Kendal Sibley, a partner at the law firm Hunton Andrews Kurth. “You could be deemed to have income, which most people think is a bad thing if you have it without corresponding cash.”

Many of these factors can be condensed into the overall loss or gain taken over the course of the building’s ownership.

“If you put $6 million into a deal, over the life of the deal, what was your return? How much cash did you actually get back?” said Gilman. “Let’s just say you got zero cash back. At the end of the day, I know I have a $6 million loss. But, if I took losses of $10 million in the past, then I may have to pick up $4 million of income. But my net number is going to be $6 million. It can’t be anything different from an investor standpoint. On the flip side, the building might have been generating income, and I might have gotten $2 million back. Well, now I know I’m going to have a $4 million net loss, because I’ve gotten back two of my six.”

So, when Gilman’s clients ask him for projections of losses or gains after a building’s sale, he directs them to consider the losses and gains associated with the investment over the complete history of their ownership or investment.

“Investors will come to me, they’re selling a building at a big loss, and they want to know, ‘What should I project? Am I going to owe money? How big’s my loss going to be?’ And I’m like, ‘You may not have a loss. You may have income,’ ” said Gilman. “The way I tell them to look at it is, go back and say, ‘How much money did I put in? How much money have I received?’ That’s your global loss or income.”

When dealing with the sale of a building, then, at what seems like a loss in today’s market, it’s important to remember that determining losses and gains might be more complex than it appears, and that the only way to know for sure is to examine your complete financial history associated with the property.

“You have to look at your entire history from day one,” said Gilman.