No one sets out to develop or own real estate to sell at a loss. Unfortunately, the unprecedented downturn in the real estate market has left many developers and owners of commercial real estate holding property worth less than its cost.

If you earned considerable income from real estate during the boom years, you also paid significant taxes during those years. Selling property now at a loss creates an opportunity to recoup some of the taxes paid in prior years. This is the silver lining in the current market gloom, and may present opportunity for some owners: Losses could mean tax refunds.

Real estate held by developers is treated as inventory. A developer recognizes ordinary income or losses (rather than capital gains or losses) when it sells its real property. Real estate held as rental property or used in a trade or business by non-developers generates ordinary losses (called Section 1231 losses) or capital gains when sold.

Ordinary losses generated by sales of real property are combined with other income and losses of a regular corporation to determine whether the corporation has an overall “net operating loss” for the tax year. Net operating losses may be carried back to prior years to decrease the tax in those prior and more profitable years. The decrease in tax is refunded to the taxpayer.

Taxpayers may carryback net operating losses realized in either 2008 or 2009 to the five previous tax years. The current law provides that net operating losses in other years may only be carried back two years prior. It is possible that Congress will again extend the carryback period but that change is not, as of the date of this writing, in current legislation. Any net operating losses left over after the carryback period may be carried forward for 20 years.

It’s tax law, so it’s complex. This sounds straightforward so far, but like so many things involving tax law, there are complexities. The passive activity loss rules may free up suspended prior year losses on the sale of the real property. Also, ordinary losses realized from the sale of real property by a non-developer may cause future capital gains realized from the sale of business property to be characterized as ordinary income.

Individual circumstances vary and, of course, you should seek advice from your tax professional before you sell any real estate used or held in a trade or business. Variables affecting this strategy include entity type, passive activity loss rules, and recapture of prior tax benefits.

For example, losses realized by partnerships and S corporations from the sale of real estate are passed through to the partners or shareholders. The partner or shareholder must have basis and amounts at risk in their partnership units or S corporation stock before the loss is allowed. Allowable losses are then netted against other income of the partner or shareholder to determine whether there is an overall net operating loss for the tax year.

What will happen next? Industry-wide effects may arise if large waves of commercial properties fall upon the market. First, the value of all properties may decline as the available inventory in the market increases. Second, the availability of more commercial rental space may result in falling rents that, in turn, apply more pressure to property owners. Third, lenders who reacquire real estate from the debtor-owners may face increased cash flow needs to maintain the property.

Commercial property owners are faced with difficult decisions in this extraordinary time. While it may be a tough pill to swallow to sell your property at a loss, it could very well be the best decision for you depending on your situation.

The views expressed in this column are those of the author and not of ALM’s Real Estate Media Group or its publications.

Dennis Fitzpatrick is a tax principal with Kaufman Rossin. in Miami. He can be reached at dfitzpatrick@kaufmanrossin.com.

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