Taxation in Real Estate: Top Considerations When Navigating Debt Forgiveness

Today’s business environment is difficult to navigate when considering higher interest rates, whose effects trickle throughout the economy. Due to changing interest rates and lower occupancy, real estate owners may struggle to meet their debt service coverage needs.

In this article, we will seek to understand the tax implications of debt forgiveness through a debt restructure or foreclosure and suggest some potential solutions to avoid incurring unnecessary taxes. This is especially impactful in the commercial and multi-family real estate sectors, where real estate is held through a partnership structure.

Is Debt Cancellation Taxable? 

Depending on your specific situation and the type of loan you have, canceled debt may be taxable.

When you take out a loan, you are legally obligated to repay a specific amount to the lender that originated the funds. That outstanding balance is considered debt and you and your co-borrowers will be responsible for paying it off at a later date. 

If the lender forgives a portion of your debt, you no longer have to repay the full loan amount and the debt will be considered canceled. A lender may decide to cancel debt for a number of reasons, such as a borrower’s financial hardship, foreclosure, repossession or modifying mortgage terms.

While you don’t have to repay the forgiven loan amount, the Internal Revenue Service (IRS) will view the canceled debt as a form of income — which is taxable — and the lender must report it using a Form 1099-C. However, if you have collateral securing the loan, taxation will be dependent on the type of debt you have.

Recourse Versus Nonrecourse Debt 

The distinction between recourse versus nonrecourse debt is an important part of a sale or exchange of the underlying property. If the lender forgives a part of your debt but also seizes the property used as collateral to settle the remaining amount, the transfer of ownership will be seen as a sale. Whether this sale is taxable will depend on if you are personally responsible for the debt (recourse) or not (nonrecourse).

Recourse Debt Forgiveness 

With recourse debt, one or more of the partners guarantees repayment of the loan, and the lender can pursue repayment with the sale of the collateral. The borrower will receive the fair market value (FMV) of the property through the sale, which goes toward the outstanding loan balance. The amount of the debt that exceeds the FMV when it is sold is considered ordinary income and is taxable.

Nonrecourse Debt Forgiveness 

Nonrecourse debt means that the lender can only pursue the collateral in the partnership to help satisfy the debt of the partnership. The amount of debt that is canceled in a sale of the property will be added to the sales price, which will increase the capital gain recognized if the property was held for longer than a year.

Whether ordinary income or capital treatment is most beneficial depends on other tax attributes that the partner has in a tax year. It’s crucial for a partner in this situation to reach out to their tax advisor because each partner’s overall tax situation may be different.

What Options Are Available If You Cannot Pay Off Your Debt? 

If you find yourself in a situation where you can no longer make payments to your lender, there are a few options you can consider:

Debt Restructuring 

When debt is restructured — and a portion or all of the remaining principal is forgiven — it can cause two specific tax issues. The first is an ordinary gain on the amount of principal that is forgiven. That gain will be allocated to the partners, which will likely result in taxable income. The second is the forgiveness of debt for which a partner previously had tax basis and related losses. This will reduce the partner’s outside basis, which could lead to an immediate taxable event or a potentially larger capital gain when the partner disposes of their partnership interest.

It is advisable to involve tax advisors prior to any restructuring in order to examine the often-overlooked tax impacts of such restructuring. Once the transaction is completed, there may be very little that your tax advisor can do.

Foreclosure

Debt restructurings are not always feasible, and foreclosure may be the final outcome. The partnership will potentially recognize gain on the foreclosure of the property and taxable income on the forgiveness of debt based on the amount of debt that was held at the time of foreclosure. 

In lieu of foreclosure, current investors can make capital contributions, or fresh capital may be sought. Oftentimes, an infusion of capital will pave the way for a refinancing of the project. 

Debt Cancellation Tax Exemptions

Taxpayers in the following situations have an exclusion from recognizing gross income cancellation of debt income:

  • Title 11 Bankruptcy Cases
  • Insolvency
  • Indebtedness Relating to Qualified Farm Indebtedness

Also, if the taxpayer is not a C corporation, and the indebtedness discharged is qualified real property business indebtedness (defined as indebtedness connected with real property used in a trade or business that is secured by the property), there will be an exception. But please note, if excluded under this provision, the amount excluded will reduce the basis of the depreciable real property connected with the debt.

Indebtedness discharged as qualified principal residence indebtedness that is discharged or subject to a written arrangement before January 1st, 2026 could be exempt as well.

Congressional Relief May Be In Sight for Debt Forgiveness Taxation 

Bipartisan legislation (H.R. 5580) was introduced in the House of Representatives in September 2023. The legislation amends the tax code to allow commercial real estate borrowers to defer tax applied to their property investments where a debt modification has taken place. Congress is aiming to reduce the distress of upcoming loan maturities in the next few years, where some defaults will occur.

Let Us Guide You Forward

There are several items in the tax code to consider when debt is partially forgiven, or even canceled and the unaware may exacerbate their situation by incurring additional tax that could have been avoided. It is imperative for a taxpayer facing a distressed real estate situation to contact their tax advisor before making any decisions.

Our Real Estate & Construction professionals are here to answer your questions concerning the cancellation of debt income and tailor a strategic plan to cover objectives such as effective tax strategies, structuring developments and profitability analyses. Please contact one of our professionals as early as possible in the process and we will assist with the best tax structure the tax code provides.

Connect With Us

Related Insights

Contributor

Connect With Us

Lee Dodson

Tax Services

Sr. Manager, Cherry Bekaert Advisory LLC