Buying a Home Foreclosures Insight

Real estate foreclosure can be tactic, not tragedy

Sunday, June 05, 2005

By Elwin Green, Pittsburgh Post-Gazette

Foreclosure. For most people, the word is emotionally charged, layered with implications of the fear, despair and shame that can accompany the loss of one's home. Foreclosure represents the end of the line, the bottom of the barrel, the point at which things could scarcely get any worse.

So when a Downtown office building goes up for sheriff's sale as a result of foreclosure, and then a second, and then a third -- as is happening tomorrow with the U.S. Steel Tower, on the heels of Dominion Tower and Warner Centre earlier this year -- the conclusion seems obvious: Downtown is in shambles.

Well, not necessarily. In fact, for the commercial real estate investor, foreclosure may simply be a strategy for gaining title to a property, one of several that investors use to maximize profits and privacy, and to minimize taxes and risk.

In such instances, foreclosure is merely the final step in a process that may have begun years before, with an agreement between a property owner who wants to be rid of a property and an investor who wants to acquire it.

The process basically works like this: Instead of buying the property outright, the investor will buy the mortgage attached to the property. No cash goes to the property owner; rather, it goes to the lender that had been holding the mortgage. Now the investor owns the mortgage, and is entitled to receive the mortgage payments from the property owner.

The property owner then skips a mortgage payment, or several, giving the investor the right to foreclose. Upon foreclosure, the property goes up for auction at the sheriff's sale, where the investor places a bid for the amount of the mortgage plus costs.

Because the investor already owns the mortgage, the only out-of-pocket costs would be the processing and related legal costs associated with the sheriff's sale. If no one outbids the investor, then he or she -- or more likely the investment group -- takes possession of the property.

For the investor, the primary advantage of this process is that a sheriff's sale generally discharges any liens against a property (other than municipal tax liens). A second benefit is that the transaction is exempt from real estate transfer taxes, an exemption that was originally created as a concession for mortgage lenders.

"The concept is that the lender typically did not want to own the property, and that if they foreclose, they would at some point turn around and sell it, at which point there would be a transfer tax payable," said attorney Jack Barbour of Klett Rooney Lieber & Schorling.

In Pittsburgh, realty transfer taxes total 4 percent of the purchase price, so the exemption can save investors millions of dollars.

For instance, local real estate professionals peg the value of the U.S. Steel Tower from $200 million to $250 million. If it were sold for $200 million in the traditional way, the realty transfer tax would be $8 million. When the building goes up for sheriff's sale tomorrow, the holder of the mortgage, 600 GS Prop LP LLC, expects to take possession of it while avoiding the need to pay that tax.

If the parties want to avoid the publicity that a sheriff's sale can generate, the owner can grant the investor a deed in lieu of foreclosure. With this approach, as before, the investor buys the mortgage, and the owner skips one or more mortgage payments, giving the investor the right to foreclose.

But instead of going through foreclosure, the owner simply surrenders ownership of the property, handing over the deed to the investor in a transaction that is much quicker and simpler than foreclosure. It can be done "as quick as a lender and a borrower can agree to do it," Barbour said, while "a sheriff's sale is probably a minimum of six months."

Like foreclosure, this approach avoids the need to pay realty transfer taxes. On the downside, it does create more risk that other creditors may require the new owners to settle liens they have against the property.

For the property owner, these approaches have the disadvantage of not putting any cash into his pocket. But if a straightforward sale would not have generated enough cash to do more than pay off the mortgage anyway, they leave the former owner no worse off.

However, if there is a profit to be gained, the owner and the investor may agree on a different approach: Instead of the investor buying the property directly, he may buy the legal entity -- typically a partnership of some kind -- that owns the property. Control of the property changes hands, but the property itself doesn't, and therefore the transaction can be free of the realty transfer tax.

But it is not automatically so. In 1997, the Simon DeBartolo Group avoided paying nearly $2 million in transfer taxes when it took control of South Hills Village shopping center by buying out the mall interests of the New York State Teacher's Association. But in 2000, Allegheny County Common Please Judge Max Baer ruled that the transfer was subject to the tax. In 2001, Simon DeBartolo and the municipalities of Bethel Park and Upper St. Clair agreed to settle out of court.

The sale of CNG Tower (now Dominion Tower) in 2000 also was scrutinized because the investor group, led by Oxford Development Co., technically bought the partnership that owned the building rather than the building itself, thus avoiding $2.7 million in transfer taxes on the $82 million transaction.

Ira Weiss, solicitor for the Pittsburgh Public Schools, was among those doing the scrutiny. In the end, he said, "We decided that this transaction wasn't of a type and nature that was subject to real estate transfer tax." The state and county also reached the same conclusion, he added.

"Both the state and most municipalities have said that if more than a certain percentage of the entity's assets consists of real estate, then that transfer is taxable," Barbour said. The percentage that triggers the transfer tax varies by location.

Even so, he added, "The sale of entities can still provide opportunities for legitimately avoiding the tax."

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(Elwin Green can be reached at egreen@post-gazette.com or 412-263-1969.)

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