If you have talked to anyone about real estate values recently, you likely have heard of at least one example in which a property is "under water" and the owner is facing difficult decisions.  Figures released by a reputable research organization show this is far from an isolated problem. According to Real Capital Analytics, a total of $93 billion worth of office, industrial, retail and apartment properties in the United States had fallen into default, foreclosure or bankruptcy as of July of this year. The firm also reported "the equity in $1.3 billion of properties is at great risk if not already wiped out since properties acquired or refinanced in 2006-2008 have seen price declines of 25% or more."

Many real estate investors who have seen their properties lose significant value in this down market are currently facing a perplexing quandary--continue servicing the debt despite lower or no tenant income, face an uphill and expensive battle to refinance or hand the keys back to the lender in lieu of foreclosure.

In all scenarios, the investor should expect to contribute additional equity. Even if the deed in lieu option is chosen, it will be deemed a sale by the IRS and the owner (seller) will be subject to federal capital gains, depreciation recapture and other applicable state and local taxes. The result is a tax liability on the gain at a rate of 20% or higher.

Faced with these distasteful choices, savvy investors are now opting for a less costly option--enter into a deed in lieu of foreclosure agreement with their lender and then engage in a 1031 exchange transaction involving the purchase of a highly leveraged, zero cash flow property. This strategy potentially allows the investor to defer the tax liabilities for 20 years or longer on the "sale" of the property that was given back to the lender.

In this scenario, the investor will be required to contribute minimal equity on the purchase of the zero cash flow property. That contribution on average amounts to about 10% to 13% of the outstanding debt on the newly acquired property.  The remainder of the exchange value is satisfied by the assumption of an existing, non-recourse loan.  Therefore, an investor could secure a 1031 replacement property that has $10 million of debt in place for as little as $1 million in cash.  This can be a much more palatable option for the investor than paying twice as much to settle the tax liability.

A 1031 exchange involving zero cash flow properties is becoming a compelling alternative for investors that have already or will likely face default on their loans or have been unsuccessful or are unwilling to obtain refinancing on their debt obligations.  We at Stan Johnson Company are currently working with a number of clients in this position to advise them on potential solutions.  In these difficult times, zero cash flow properties offer the lowest cost solution, in terms of equity contribution, available today.  We believe the market will see an increasing number of investors choosing this option once they realize its attractiveness.