The Hidden 'Double Whammy' Facing Owners Who Hand Buildings Over To Lenders

With billions of dollars worth of commercial real estate loans coming due, landlords with struggling properties are increasingly giving the keys to lenders and walking away.

The decision amounts to owners trying to wash their hands of an investment gone bad, but many have found out the hard way that it isn’t so simple. These transactions — known as deed-in-lieu-of-foreclosure sales — could wind up saddling them with a large tax bill.

By doing a deed-in-lieu-of-foreclosure transaction, a borrower hands the property to the lender in exchange for guarantees against legal action or further payments of the debt. For struggling landlords, it’s an appealing option.

But debt forgiveness is taxable income, and any loan amount that exceeds a building’s original value — common among CRE owners who have refinanced a property multiple times — is taxed as a capital gain if the debt is forgiven. The capital gains tax rate can reach 37%.

“It’s tough,” said Brian Granath, a partner with Atlanta-based OA Development. “When you hand your investors a total loss and then hand them a gain on their K-1, it’s a brutal situation. You hand your investors a phantom gain.”

Handing back the keys has become increasingly common in recent years. On average, 16% of commercial foreclosures over the past five years have been deed-in-lieu transactions, according to data compiled by CoStar. At the end of last year, that percentage skyrocketed to 46%. In the first quarter, the rate was 41%.

That equates to 70 deed-in-lieu transactions spanning office, industrial, multifamily, hotel and retail properties in the first quarter, following 93 properties handed to lenders in the last three months of 2023.

Those borrowers might have a rude awakening come tax season.

“There are some people who own some significant properties where we’ve seen they weren’t aware of the significant pitfalls by just throwing back the keys,” said Rob Gilman, group leader for the New York-based accounting firm Anchin.

Many commercial properties purchased when interest rates were at historic lows are facing revaluation. The average drop in value of a distressed commercial property was 43% between midyear 2023 and 2024, according to Cred iQ.

That means the delta between the value of the original loans versus what the property is worth today creates a scenario where some borrowers actually end up paying capital gains taxes if they give the property back to the lender, Gilman said.

“At the end of the day, if you have a negative capital account and if you give back the keys, you’re going to have a tax hit for that negative investment,” Gilman said. “It’s almost as if you sold that building for nothing.”

Examples of owners giving properties to their lenders continue to pile up.

In May, an affiliate of Clarion Partners handed in the keys to a 135K SF D.C.-area office building known as the Portrait Building to Voya Investment Management over the $33M outstanding balance on a $41M loan, the Washington Business Journal reported. Two South Florida investors returned a 20-acre luxury yacht marina to Fortress Investment Group after they didn't make payments on their $81.7M loan, The Real Deal reported.

In July, Chicago-based coworking firm Expansive gave back the keys to its 115K SF Downtown Denver office building at 1630 Welton St. to RRA Capital to satisfy a $12M loan, according to BusinessDen.

“Really, it’s a classic office story. It’s overleveraged,” Expanse Chief Financial Officer Chris Klare told BusinessDen at the time. “Both the lender and us were trying to find the best solution for everyone.”

It is unclear what tax penalties the borrowers had to pay in those examples. None responded to requests for comment.

For smaller investors that may not have the wherewithal to obtain nonrecourse debt, handing in keys to a property can create an even steeper tax bill, Moore Colson Tax Director Tracy Burton said. If the lender forgave any part of the balance of the loan, the IRS can tax that amount up to 37%. 

“Maybe for smaller investors, where they have to personally guarantee their loan, the [move] can trigger both a deed-in-lieu capital gains sale and forgiven debt by the lender,” Burton said. 

Institutional investors and larger, sophisticated owners generally anticipate the tax consequences of a deed-in-lieu. But smaller investors can be in for a shock, said Michael Schmied, the co-founder of the Swiss loan consulting firm Kredite Schweiz.

“A client came to me, shocked, because they thought returning the property would just wipe the slate clean,” Schmied said via email. “But they didn't realize that the forgiven debt — the amount of the loan that was higher than the property value — could actually be seen as taxable income.”

For one of Schmied’s clients, the solution out of a hefty tax bill was to declare insolvency, he said.

“I’ve seen this catch so many people off guard, so I make sure to always stress the importance of being prepared for that kind of outcome before they hand over the deed,” he said.

OA Development entered into two deed-in-lieu-of-foreclosure deals on suburban Atlanta office assets in 2021 and 2022, Granath said. In both instances, OA avoided tax penalties because it owned the buildings for so long, the loss of equity in the properties offset the loan values.

But Granath said that isn’t the experience other smaller investors have when turning in the keys to struggling properties.

“You’re thinking, ‘Wait a minute. I’m going to have X tens of millions loss of equity. Where’s the gain?’ People don’t realize the forgiveness of debt is a taxable event,” Granath said. “Obviously, the bigger firms with in-house advisers know it’s coming. But the smaller shops get surprised.”

One California-based commercial real estate investor, who would only speak to Bisnow on the condition of anonymity, said he knew he was going to have to give the keys back to his lender for an empty Midwestern office building after he was unable to find a replacement tenant. 

The investor said he purchased the building sight unseen in 2020, during the mandatory pandemic lockdowns, as he was rushing to execute a 1031 exchange to try to duck the capital gains tax on a building he had sold.

At the time, the building was leased to a company that used the facility as a call center and data center, which he was told was integral to its operations. Despite years left on the lease, the tenant exercised an opt-out clause and vacated the property shortly after it traded hands.

All of a sudden, the investor found himself with an empty building saddled with a $9M loan on which he couldn't make the payments. He was aware of the tax penalty that comes with a deed-in-lieu-of-foreclosure but decided to hand over the keys anyway.

“I knew the consequences of giving a building back,” the investor said, requesting anonymity to avoid damaging his reputation in the industry. “It is what it is. People don’t understand the double whammy there. Not only do you lose your property, but you’re going to owe the IRS a chunk of change.”

He said institutional groups have the sophistication to minimize or even avoid these tax penalties. Some can simply transfer properties between funds or buy a building back from a receiver with another LLC. 

“The little guy doesn’t have that ability. If you’re a small, private investor, you’re screwed,” he said. “It’s definitely a stain on your record that definitely stays there no matter what.”