A yawning bid-ask pricing gap isn’t the only force that’s assailing commercial property and debt sales. A potentially costly tax quirk is also keeping troubled properties stuck in the mud, by disincentivizing commercial owners from either working out underwater loans or giving the keys back to the bank – two moves that would lead to market-clearing transactions.

Instead, commercial real estate professionals predict, owners of distressed assets may wind up shoveling their own cash into their properties because they won’t be able to swallow the tax hit that a workout would entail.

“Property values and debt rose so fast that there are a lot of latent tax liabilities that are underappreciated, and yet to be realized,” said Seth Rosen, a vice president in the capital markets practice at Colliers Meredith & Grew. “This is the most underappreciated issue in all of commercial real estate debt, especially in the context of impending defaults.”

Those Pesky Tax Liabilities

In many commercial deals structured through LLCs, both of the obvious exit strategies available to property owners – a loan workout or a foreclosure – could wind up putting the individual members of the LLC on the hook for a large personal tax liability.

Assume, for instance, that an LLC-owned commercial property is carrying a $10 million loan on a property that’s now only worth $8 million. If the LLC gets its bank to drop its loan principal down to $8 million, the LLC’s members haven’t gained any cash benefit, but they will have recorded $2 million in taxable cancellation of indebtedness income.

Likewise, when lenders foreclose on a property, the property is deemed to have sold for the face value of the property’s debt. When that happens, the difference between a borrower’s cash basis and the value of the outstanding debt is treated as a capital gain.

“Properties that are underwater and don’t get any cash out of a sale may actually have a gain,” said David Sullivan, a partner at Nutter McClennan & Fish.

More than a year ago, Sullivan and Rosen predicted that if an economic downturn bore down on the commercial real estate sector, hidden tax liabilities would wind up falling on the heads of real estate investors. Those predictions are now playing out – especially in the cases of late-boom investors who used high levels of leverage, and have little cash basis.

“Investors who thought they had complete liability protection and were willing to walk away from a property have lost their investment, and that loss may not be enough to offset the forgiveness income,” Sullivan explained.

‘It’ll Be A Disaster’

Sullivan said that after months of concentrating on the state of their capital cushions, banks are now moving to tackle their underwater commercial loans.

“Before, they were in panic mode,” he said. “A lot of loans were underwater, and everybody knows they’re underwater, but they didn’t want to do anything about it. Now, whether internally or externally, banks are under pressure to react and move things forward.”

That pressure may foist Faustian choices upon underwater borrowers, though.

“You could be in workout negotiations and on the precipice of a deal, and you call your lawyer or your accountant and he says, ‘Wait, don’t do it, it’ll be a disaster,’” Rosen said. “It might make more sense to sit on the property and take the money out of your own pocket. They’re servicing the property out of their own pockets, not the cash flowing from the property.”

“It has quickly come to the forefront,” Sullivan added. “Banks have determined what hit they’re willing to take on a given loan. They’ve gone through the process on their books, now they’re going to the borrowers with what they think is a good deal. Smart borrowers who are running offers by their accountants and lawyers are finding out they have an issue. Banks are scratching their heads because the borrower comes back and says, ‘I can’t do this.’”

Impaired Value

The tax liabilities embedded in underwater properties don’t just pose problems for individual real estate investors, though. If investors wind up servicing debt out of their pockets because they can’t afford to work a loan out or even turn over a property to the bank, Rosen said, “the value remains impaired, and all the paper on it that’s trading is impaired.”

That keeps prices artificially inflated, and hampers the establishment of true, market-based clearing prices.

The need for clearing prices drove Congress to insert a five-year deferral of cancellation of indebtedness taxes in February’s federal stimulus bill.

“It should be one of the things that incentivizes people to move forward, instead of holding back,” said Harold Bordwin, a managing director and co-group head for real estate services at KPMG Corporate Finance. “There’s a lack of transaction velocity throughout the commercial real estate spectrum.” That velocity will only increase when borrowers are free to restructure their debt, Bordwin said.

Even so, Sullivan pointed out, the deferral option “doesn’t eliminate the tax bill. It just pushes it back. The ironic thing about the deferral is, hopefully, in a couple of years, you’ll be making lots of money again, and that’s when you’ll have it added to your tax bill.”