Contributor: Lee Dodson, Tax Senior Manager
Today’s business environment is difficult to navigate when considering the higher interest rates, whose effects trickle throughout the economy. Due to changing interest rates and lower occupancy rates, 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.
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.
Recourse Versus Nonrecourse Debt
The distinction between recourse versus nonrecourse debt is important as part of a sale or exchange of the underlying property. Nonrecourse debt means that the lender can only pursue the collateral in the partnership to help satisfy the indebtedness of the partnership. On the other hand, with recourse debt, one or more of the partners guarantees payment of the indebtedness, and the lender can pursue loan satisfaction with the sale of the collateral and look to the partners to make the lender whole.
If the debt is nonrecourse, 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. Conversely, if the debt is recourse, the amount of the debt that exceeds the fair market value of the property is considered ordinary income.
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.
Exclusions Concerning a Discharge of Indebtedness
Taxpayers in the following situations have an exclusion from recognizing gross income cancellation of debt income:
- Title 11 bankruptcy case
- Insolvency
- Indebtedness relating to qualified farm indebtedness
- 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)
- 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
Congressional Relief May Be in Sight
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.
