Tax professionals tackle challenge of large write-downs on distressed New York properties

In June of this year, a subsidiary of Related Companies sold 321 West 44th Street, a 10-story building, for less than $50 million, which represented – strictly speaking – a loss of $103 million, since the subsidiary had bought the building for about $153 million in 2018.

And in August, in a sale that shocked everyone involved, the 23-story office building at 135 West 50th Street, owned by an affiliate of UBS Realty Investors, sold at auction for a surprisingly low $8.5 million, a 97.4 percent discount to its $332 million purchase price in 2006.

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In a depressed office real estate market, many properties are selling at this price, that is, for a fraction of their previous value. As a result, sellers are faced with tax implications that they may not be used to, unlike selling properties at or near their expected value.

Given the multifaceted nature of real estate transactions, every situation will have its own unique set of circumstances. But speaking with some of New York’s top accountants and tax attorneys reveals a byzantine system in which apparent losses can 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 collaborators.)

These subverted expectations are partly facilitated by New York City’s unusual method of calculating property taxes.

“Everywhere else in the United States and perhaps the free world, property taxes are based on the market value of the property. But that’s not the case in New York,” said Stuart Saft, a partner at the law firm Holland & Knight. “Commercial property owners file income and expense statements for their property every year, and the tax assessor’s office calculates its opinion on taxes based on the income and expenses — in a sense, what they think the profit on the property would be when capitalized.”

This subjectivity can leave parts of a seller’s tax bill at the mercy of the city.

“If a property is sold for less than the original sale price, the property assessment should go down. But that’s not always the case because the city factors in sale prices as part of its assessment and will be reluctant to lower the price,” said Jay Neveloff, partner and chair of the real estate department at law firm Kramer Levin. “Assessing a property sold at a loss proportional to the reduction in value would mean the city would lose more tax revenue.”

Due to these complex origins, many factors must be considered when examining tax scenarios.

Pamela Capps, a tax partner at Kramer Levin, presents a scenario in which a commercial building is purchased for $10 million. The buyer invests $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 property because that’s what I paid for it,” Capps said. “I was able to write off my initial $3 million, plus another $5 million in tax deductions, and I took advantage of that. Now I have a negative basis in my partnership interest. So even if I sell it for less, I’m going to have a gain because I’ve written off money that I didn’t invest.”

“You can only take tax losses against the money you put into the transaction. This is a common problem in real estate sales: Because of depreciation deductions and debt on the property, you can end up with a negative basis that will result in a gain even if you sell for less than you bought it for.”

Rob Gilman heads the real estate practice at accounting and consulting firm Anchin. Gilman describes the scenario of a commercial building purchased for $30 million with $24 million in debt and $6 million in equity, which ultimately sells for $25 million.

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

But now let’s reimagine this scenario by including $10 million of depreciation taken into account since purchase.

“The tax equity is now negative $4 million,” Gilman said. “I still have money to pay the debt, but now I have a clawback because I ended up taking more deductions than I invested. An investor is going to have a $4 million gain in income.”

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

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

“There’s now a potential $4 million in revenue from debt forgiveness,” Gilman said. “In some situations, they’ll have to pay taxes on that revenue.”

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 some exceptions. “If it is taxable, you must report the canceled debt on your tax return for the year in which the cancellation occurred.”

This is especially true for recourse debts, where the borrower is personally liable for the debt.

“If you have recourse debt, you could end up with a loss on the property, but also have debt forgiveness income if the property value isn’t enough to cover the debt,” said Kendal Sibley, a partner at the law firm Hunton Andrews Kurth. “You could be considered to have income, which most people consider a bad thing if you have it without corresponding liquidity.”

Many of these factors can be condensed into the overall loss or gain incurred over the period of ownership of the building.

“If you put $6 million into a deal, what’s your return over the life of the deal? How much money did you actually get back?” Gilman said. “Let’s just say you didn’t get anything back. At the end of the day, I know I’m down $6 million. But if I’ve had $10 million in losses in the past, I might have to get back $4 million in revenue. But my net number is going to be $6 million. It’s not going to be any different from an investor’s perspective. On the other hand, the building could have been generating revenue and I might have gotten back $2 million. Well, now I know I’m going to have a net loss of $4 million because I got back two of my $6 million.”

So when Gilman’s clients ask him for projections of losses or gains after a building is sold, he asks them to consider the losses and gains associated with the investment over the entire history of their property or investment.

“Investors come to me looking to sell a property at a loss and they want to know, ‘How much should I budget for? Will I owe money? How big will my loss be?’ And I say, ‘You may not have a loss. You may have income,’” Gilman said. “I tell them to look at it this way: ‘How much money did I put in? How much money did I get out?’ That’s your overall loss or income.”

When it comes to selling a property, at what appears to be a loss in today’s market, it is important to remember that determining gains and losses can be more complex than it appears, and the only way to be sure is to review the complete financial history associated with the property.

“You have to look at your whole story from day one,” Gilman said.