Commercial Mortgage Loan Workouts – Part Two – Deed in Lieu of Foreclosure

In a previous blog, we provided an overview of the foreclosure process as well as a summary of the tax consequences of a foreclosure. As discussed in that blog, foreclosure is the worst possible result for a distressed borrower, and the goal of a loan workout is the avoidance of foreclosure. Foreclosure harms, or may harm, the hapless borrower in four ways: first, it deprives the borrower of title to the mortgaged property; second, it may result in a deficiency judgment against the borrower and any guarantors; third, it may result in taxable income to the borrower, even in the absence of any cash payment to the borrower; and fourth, it damages the borrower’s credit. In this blog, we will compare a deed-in-lieu of foreclosure to a foreclosure.

In a deed-in-lieu of foreclosure, a borrower facing foreclosure voluntarily deeds the mortgaged property to its lender rather than have the property involuntarily transferred at a foreclosure sale. While a deed-in-lieu of foreclosure results in the borrower’s loss of title to the property, it generally avoids, or at least mitigates, the other three harms that may be visited upon the borrower as the result of a foreclosure. First, contrary to the situation in a foreclosure, as a quid pro quo for the borrower’s cooperation in voluntarily deeding the property to the lender, the lender typically releases the borrower and guarantor from any liability under the loan. Second, while a deed-in-lieu of foreclosure will damage the borrower’s credit, its impact is generally not as severe as that of a foreclosure.

Finally, while a section 1031 tax-deferred exchange is normally available in a deed-in-lieu of foreclosure, a deferred exchange is generally not feasible in a foreclosure. In order to engage in a deferred exchange either legal title to the relinquished property must be conveyed to the seller’s qualified intermediary (QI) or the contract of sale must be assigned to the QI (called the “assignment safe harbor”) in which case the property may be conveyed directly to the purchaser.[1] However, in a foreclosure, there is no contract to assign; thus in order to comply with the deferred exchange regulations, legal title to the property would have to be conveyed to the QI prior to the foreclosure sale. But a title transfer without the lender’s consent would trigger recourse liability to the loan guarantor under the provisions of a typical loan guaranty. Since the lender is almost certainly not going to consent to such a transfer, such a transfer would cause the loan guarantor to be personally liable for the entire deficiency—that is, the amount by which the loan balance (plus accrued interest and lender costs) exceeds the amount received by the lender in the foreclosure sale. As a result, a section 1031 tax-deferred exchange is generally not feasible for a borrower facing foreclosure.

By contrast, in a deed-in-lieu of foreclosure, the borrower and lender typically enter into an agreement sometimes referred to as a “deed-in-lieu of foreclosure agreement” under which the borrower agrees to convey the mortgaged property to the lender in return for a release of the borrower and guarantor from any further liability under the loan. As a result, the borrower can satisfy the “assignment safe harbor” required for a section 1031 exchange by assigning the deed-in-lieu of foreclosure agreement to its QI.[2] By satisfying this safe harbor, the borrower may directly deed the property to the lender. The fact that the borrower has no equity in the property does not preclude application of section 1031 to the exchange.[3] The borrower is deemed to receive consideration in such exchange in the form of debt relief[4], which the borrower may offset with debt assumption and/or new cash consideration paid with respect to the replacement property.[5]

Thus, in an IRS private letter ruling[6] the taxpayer owned property used in its trade or business which was encumbered by nonrecourse loans whose outstanding balance exceeded the property’s market value. The taxpayer negotiated a deed-in-lieu of foreclosure agreement with its lender under which the taxpayer agreed to transfer the property to its lender subject to the debt. The taxpayer also planned to assign such agreement to its QI with notice being given to the lender. The IRS ruled that the assignment of the deed-in-lieu agreement to the QI and the transfer of the property to the lender, constituted a transfer of the relinquished property for purposes of section 1031 “notwithstanding that the fair market value of [the property] is less than the principal amount of the outstanding nonrecourse debt.”

[1] Treas. Reg. § 1.1031(k)-1(g)(4)(iv) and (v).

[2] See I.R.S. Priv. Ltr. Rul. 201302009 (Jan. 11, 2013).

[3] Id.; see also, Am. Bar Ass’n, Comments Concerning Open Issues in Section 1031 Like Kind Exchanges, Question 8 (1995).

[4] For section 1031 purposes, the QI is deemed to have acquired the relinquished property subject to the mortgage loan, and the taxpayer is deemed to be relieved of such liability.

[5] Id. Note, however, that if the mortgage debt is recourse and the loan balance exceeds the property’s market value, that portion of the loan balance exceeding the market value is considered cancellation of debt income (CODI). Since CODI is considered ordinary income (See I.R.C. §61(a)(12)) rather than gain from the sale or exchange of property, it may not be deferred in a section 1031 exchange. Under certain circumstances, however, CODI may not give rise to taxable income to the borrower.

[6] I.R.S. Priv. Ltr. Rul. 201302009 (Jan. 11, 2013).