Examining PLR 201302009 & Underwater Property

PLR 201302009 & avoiding cancellation of indebtedness on underwater property

Private letter rulings (PLR) offer insight into where certain boundaries lie. PLR often provide solutions to problems that practitioners are likely to encounter.

PLR 201302009 offers a solution to a common problem faced by many real estate operators for borrowers whose property is underwater. The solution is a like-kind exchange; however, it may not be useful to all operators, but it does offer a way out to taxpayers who are able to arrange new financing on a purchase of replacement property.

The problem in a like-kind exchange is that relief of indebtedness is treated as the receipt of cash, which is boot and must be recognized as income. Fortunately, taxpayers are permitted to net liabilities. The debt on the relinquished property a taxpayer is relieved of debt is offset against the new debt being assumed and cash down payment given in connection with the replacement property. This netting is the key to avoiding phantom gain from relief of indebtedness.

What does this mean for the taxpayer?

The PLR states that the value of the replacement property is approximately equal to the amount of debt on the relinquished property. It may not be possible to find suitable replacement properties let alone find one that will qualify for financing in an amount equal to the debt on the relinquished property. Although not stated in the PLR, the taxpayer probably had the wherewithal to come up cash to fund the balance of the purchase price. One must assume that the new lender was not inclined to fund the entire purchase. Thus, this solution may be of little use to taxpayers in deep financial distress.

The mechanics of the exchange are relatively straightforward with the exception that the consent of the lenders to the relinquished property was secured, no doubt, beforehand. This taxpayer is engaged in extensive negotiations with his or her lenders, identified replacement property, obtained new financing and a private letter ruling.

In addition to the cash payment on the replacement property, all of this suggests a well above-average taxpayer with resources and foresight. Those in distress may not have the cash nor the forbearance of its lenders to carry-out a similar plan. This may be a solution for taxpayers able to service their debt but who are looking to address the issue of an underwater property.