Receivers May Reduce a Lenders Tax Liability on the Sale of Subdivisions

Marc Brooks called me the other day and announced, ”You know, a lender who forecloses on a new subdivision development that was collateral for a non-performing loan may have to pay ordinary income taxes on all of the sales proceeds as a real estate ‘dealer’. On the other hand, when a borrower or a court appointed receiver sells out the subdivision and pays down the loan, the lender gets to remain a lender.” Marc Brooks is the founder and Executive Vice President of Mara Escrow and Mara Exchange, and has several thousand subdivisions under his belt, so he’s a pretty experienced guy. However he is not a tax expert (as he would readily acknowledge).  So I was a little surprised to get the call. I in turn called a tax expert, and he concluded that Marc may be right, subject to the specific circumstances of the loan and the lender.

Generally, as I understand it (and I’m not a tax expert either) the federal tax code says that the owner/developer of a new subdivision that sells more than four units or parcels (the rules are fairly arcane) is a ‘dealer’ and must pay ordinary federal income tax on profits from the sale of the subdivision units or parcels. A lender who is repaid the principal of a construction or development loan by a borrower would only pay taxes on the interest earned. Today this isn’t a big issue for traditional lenders, since in most cases they’re already swimming in losses.

However, it could be pretty important for investors who buy non-performing loans (typically construction loans secured by 1st trust deeds) at a steep discount, and step into the shoes of the lender. It may also be important for profitable lenders who have fully charged off their loan losses, and now stand to make a profit on the sales of their foreclosed real estate. When a lender forecloses on a loan and sells the subdivision, they may become a ‘dealer’ and pay ordinary income taxes on the profit from those sales. However, if the borrower (or a court appointed receiver acting in place of the borrower) sells the subdivision and pays down the loan from the proceeds, the borrower remains the ‘dealer’. The lender remains a lender and receives the repayment of principal and interest from the loan. Depending upon the lender’s basis in the loan and their hold period, the lender may be taxed on the loan proceeds as long term capital gains and not ordinary income.  That’s potentially a 20% reduction in federal income taxes, not an insignificant sum.

Of course, these are pretty complex tax issues and neither Marc Brooks nor I are qualified to give tax advice, so make sure you consult your CPA, tax attorney or other qualified tax advisor before you make any business decisions.