No-Sweat Workouts

Avoiding taxes on commercial loan restructuring.

Clients with commercial real estate financial problems may need loan workouts with their lenders to reduce their debt. Along with the financial and legal issues surrounding loan restructuring, your clients may face additional taxes.

In a loan workout, a debtor can realize cancellation of indebtedness income (COD income) if new debt is issued to the property owner in exchange for the cancellation of the property owner’s old debt or if there is a “significant modification” of the existing promissory note. Lenders report to the IRS a property’s foreclosure or abandonment on Form 1099A, and certain lenders are required to report to the IRS a borrower’s COD income on Form 1099C.

Single-family residential foreclosures and debt relief are governed by special tax rules beyond the scope of this article (see “Tax Aspects of Foreclosures and ‘Short Sales’,” January/February 2009 California CPA).

Under the recently enacted American Recovery and Reinvestment Tax Act of 2009, clients can elect to defer recognizing COD income in connection with debt instruments used in the conduct of a trade or business [IRC Sec. 108(i)].

This tax rule would apply to real estate debt issued in the conduct of a trade or business, which is forgiven or modified (and treated as an exchange of debt instruments), between Dec. 31, 2008, and Jan. 1, 2011.

The COD income deferred is then included in the client’s gross income ratably over a five-year period beginning in 2014. However, there is a provision to accelerate the COD income if the taxpayer dies, ceases business or sells substantially all of its assets. Thus, this new rule may be of limited help in the real estate context.

Recourse or Nonrecourse
When your client’s real estate is foreclosed upon or a deed is given to the lender in lieu of foreclosure, the tax consequences of whether your client will be taxed as a “sale” of the real estate or realize COD income depends on whether that promissory note is recourse or nonrecourse.

COD income is taxable to a property owner as ordinary income under IRC Sec. 61(a)(12), but the property owner/borrower may be able to exclude that COD income under IRC Sec. 108 or defer recognizing it under IRC Sec. 108(i). However, COD income is not realized for that portion of the foreclosure classified for tax purposes as a “sale” of the real property.

Recourse Promissory Note: When the lender forecloses on real estate secured by a recourse promissory note, the foreclosure is taxed to the client/borrower in two portions:

The “sale” portion: client realizes taxable gain equal to the fair market value of the foreclosed real estate less client’s tax basis in that real estate.
The COD portion: the amount of indebtedness that exceeds the fair market value of the real estate. This portion may carry tax advantages since it can be excluded from your client’s income.

Nonrecourse Promissory Note: Foreclosure of real estate secured by a nonrecourse promissory note means that the lender cannot obtain a judgment against your client for that loan’s deficiency amount. Thus, there is no COD income. Instead, upon foreclosure—or if a deed is given to the lender in lieu of foreclosure—your client realizes taxable gain as a “sale” equal to the outstanding debt less your client’s tax basis in the property.

Creating COD Income to Use Sec. 108 Exclusions
Converting nonrecourse debt to recourse debt can create COD income applicable for IRC Sec. 108 exclusion, but this carries a risk of a later deficiency judgment against your client.

Your client also could renegotiate the loan with the lender rather than be taxed as a sale of the property by a foreclosure. This would reduce the property’s debt and use one of the IRC Sec. 108 COD income exclusions. A loan reduction, whether the loan is recourse or nonrecourse, will be entirely COD income.

Bankruptcy and Insolvency Sec. 108 Exclusions
A bankrupt or insolvent client’s COD income is excluded from income [IRC Sec. 108(a)(1)(A) and (B)]. The amount excluded may not exceed the amount by which that borrower is insolvent under IRC Sec. 108(a)(3). If the property owner is a partnership, then these two exclusions apply to the partner—if that partner is bankrupt or insolvent—and not to the partnership.

The individual or partner is deemed to be insolvent to the extent that individual’s or partner’s liabilities, immediately before the cancellation of indebtedness, exceeds the fair market value of the individual’s or partner’s assets [IRC Sec. 108(d)(3)].

When the Sec. 108 bankruptcy or insolvency COD income exclusions are utilized, your client must reduce certain of its tax attributes in the following order: net operating losses; general business credits (IRC Sec. 38); minimum tax credits (IRC Sec. 53); capital loss carryovers; the tax basis in property; passive activity loss and credit carryovers; and foreign tax credit carryovers.

These tax attributes are reduced after the tax year for which the debt discharge is determined and thus do not impact your client’s tax liability for the year of debt discharge.

Qualified Real Property Business Indebtedness Exclusion
Forgiveness of debt that was incurred or assumed by your client to acquire or construct real estate used in a trade or business, and is secured by that real estate, can be excluded income under the qualified real property business indebtedness exclusion to COD income [IRC Sec. 108(a)(1)(D)]. The property owner must make an election on Form 982 (attached to the electing taxpayer’s return for the year of debt discharge). The amount excluded from income reduces your client’s depreciable real property tax basis.

However, when the property, which had its tax basis reduced is sold, the income caused by that real estate’s lowered tax basis will be taxed back to your client at higher ordinary income rates, rather than at lower long-term capital gains rates.

Sec. 1031 Exchange to Avoid Taxable Gain Recognition
An option for clients facing foreclosure of their property with a low tax basis, and thus potential taxable gain, is to exchange the troubled real estate as relinquished property for real estate with equal or more indebtedness (IRC Sec. 1031).

A requirement to note is that there must be an “exchange” of the relinquished and replacement properties. If the relinquished property has no equity because its debt exceeds the value of the relinquished property, then there is a tax issue as to whether this requirement has been satisfied.

A New Partner’s Cash Contribution
For troubled real estate owned in a partnership, a new cash-contributing partner could be admitted. The partnership utilizes the new cash to cure the debt default and make loan payments. The original partners remain as smaller-percentage, interest partners so as to avoid gain recognition and, thus, are able to defer their built-in gain until the partnership’s property is sold.

For the original partners to avoid gain recognition from an imputed distribution of cash (based upon the reduction of their share of the partnership debt when the new partner is admitted), they must keep an adequate share of the partnership debt for tax purposes under IRC Sec. 752.

Have the Lender Take Back a Partnership Interest
The lender may agree to take back a partnership interest in exchange for canceling the partnership’s debt. The borrowing partnership does not have COD income to the extent of the fair market value of the partnership interest received by the lender. However, the partnership realizes COD income to the extent that the fair market
value of the partnership interest received by the lender is less than the amount of the debt discharged.

Prop. Treas. Reg. 1.108-8 states that the fair market value of the partnership interest can be based upon its “liquidation value,” provided certain conditions are met.

Friendly Third Party Acquires Promissory Note
A client owning troubled real estate can avoid recognizing COD income if an unrelated, friendly third party acquires the promissory note from the lender. The friendly third party can then allow your client more time to cure the debt default.

If a party “related” to your client acquires the debt from the lender, then that client/debtor would be treated for tax purposes as having acquired its own indebtedness, which in turn would generate COD income.

To avoid COD income being generated after the unrelated party acquires the promissory note, there should not be a “significant modification” of that note.

Create Deductible Tax Losses from Troubled Real Estate
Where the tax basis of the foreclosed property is greater than the debt encumbering it, a tax loss may be realized upon that property’s foreclosure or abandonment. In most cases your client will want that tax loss to be an ordinary loss.

If your client abandons real property or a partnership interest, or if such property or partnership interest is deemed worthless, then there is a completed transaction whereby the tax loss can be recognized. There will be an ordinary tax loss if there is no sale or exchange treatment. Thi is the case if the abandoned or worthless property is not subject to an indebtedness for which there is a foreclosure or deed in lieu of foreclosure.

When a partnership interest is abandoned and the partner has a share of the partnership’s liabilities for which that partner is being relieved under IRC Sec. 752, there will be a deemed partnership distribution to that partner under IRC Sec. 731. This produces a capital, rather than ordinary, loss to that partner.

On the other hand, if a partnership interest is abandoned and that partnership has debt, but the partner has no share of that debt under the partnership tax rules of IRC Sec. 752, there is no sale or exchange, which results in an ordinary loss for that partner’s abandoned partnership interest.

To avoid the limitations on deducting capital losses, if the tax loss recognized on your client’s property’s foreclosure is an IRC Sec. 1231 loss (rather than a capital loss), then that loss can be offset against your client’s ordinary income.

Many options are available to clients engaging in loan workouts or facing foreclosure of their commercial real property, and the key is understanding the tax consequences of each strategy.

Robert A. Briskin, Esq., is a certified specialist in taxation law in Los Angeles.