Editor: Anthony S. Bakale, CPA, M. Tax.
Today’s volatile real estate environment presents interesting opportunities for investors and developers to alter the terms of their debts in ways that may pay off if they can retain control of their projects. The downside to doing so, though, is that they may recognize cancellation of debt (COD) income. At the same time, other developers will be facing foreclosure and phantom income from debt relief. With foreclosures and significant loan modifications the order of the day, real estate owners, investors, and their tax advisers need to be aware of the COD rules and plan carefully for the tax implications of these transactions.
The American Recovery and Reinvestment Act, P.L. 111-5, allows certain taxpayers who realize income from COD in 2009 or 2010 to defer that income and recognize it ratably over five years, beginning in 2014 (Sec. 108(i)). For taxpayers electing to defer COD income under this new law, the other COD exclusions in the Code would not be available. However, already existing provisions may provide a much greater benefit.
This new provision defers the recognition of income for only a limited period of time. Other COD rules already existing in the Code may be more beneficial by providing for exclusion of COD income. Bankrupt or insolvent taxpayers may be able to escape recognition of COD income entirely, depending upon their specific circumstances. Qualified real property indebtedness may also be excluded, depending upon the taxpayer’s circumstances.
The rules for COD income vary depending on whether the debt related to the property being foreclosed upon is subject to recourse debt, nonrecourse debt, or partially recourse and partially nonrecourse financing.
COD Income Rules for Recourse Debt
When a lender forecloses on property in satisfaction of a recourse debt, the foreclosure is deemed to be a sale, with the sales proceeds equal to the amount of the debt or the fair market value (FMV) of the property, whichever is less. The difference between the deemed sale proceeds and the property’s cost basis equals the gain or loss on the sale. To the extent the debt exceeds the property’s FMV, the taxpayer is deemed to have COD income. In other words, when the property has recourse financing, the transaction is bifurcated into two transactions, a sale transaction and a COD transaction.
Since a foreclosure is treated as a sale or exchange of property, the character of any gain or loss is determined in accordance with the provisions of Secs. 1221 and 1231. As a result, if the mortgagor had held the property as a capital asset under Sec. 1221 or for use in a trade or business under Sec. 1231, any gain is a capital gain or a Sec. 1231 gain. In the case of Sec. 1231 assets, the gain is also subject to the recapture rules in Sec. 1250. Alternatively, if the property was held primarily for sale to customers in the ordinary course of business under Sec. 1221(a)(1), the mortgagor recognizes ordinary income or loss from the transaction.
If the amount of the debt is greater than the FMV of the property, the deemed sale proceeds are equal to the FMV. The debt minus the deemed sale proceeds equals COD income.
Taxpayers must also plan for gain or loss on the foreclosure in addition to COD income. The deemed sale proceeds (in this case, the property’s FMV) minus the cost basis equals the gain or loss, just as if the property were actually sold. The gain or loss may be capital, Sec. 1231, or ordinary, depending on the character of the property in the taxpayer’s hands.
If the property’s debt and cost basis are both greater than the FMV, the taxpayer will have both COD income (debt minus FMV) and a Sec. 1231, ordinary, or capital loss (FMV minus basis). This is known as a bifurcation.
The tax implications are more straightforward if the amount of the debt is less than the property’s FMV. Here, the deemed sale proceeds are equal to the debt, and there is no COD income. The taxpayer has gain or loss on the deemed sale (which may be capital, ordinary, or Sec. 1231).
COD Income Rules for Nonrecourse Debt (Including Qualified Nonrecourse Debt)
A lender’s foreclosure in satisfaction of nonrecourse debt, including qualified nonrecourse debt, is treated as a deemed sale, with the proceeds equal to the amount of the debt. The property’s FMV is irrelevant, and there is no COD income. The tax implications are determined based on the amount of the debt and the basis of the property.
If the amount of the discharged debt is greater than the property’s cost basis, the taxpayer will have income (capital, ordinary, or Sec. 1231) on the foreclosure transaction. However, since the gain is not treated as COD income, none of the income exclusion exceptions under Sec. 108 discussed later in this item are available— even if the taxpayer is bankrupt or insolvent. The gain in this scenario is includible in the taxpayer’s gross income for the year. This taxpayer-unfriendly rule is the major difference between foreclosures involving recourse and nonrecourse debt. Alternatively, if the debt is less than the property’s cost basis, the taxpayer will have a capital, Sec. 1231, or ordinary loss depending on the nature of the property.
COD Income Rules for Partial Recourse Debt
If a debt is a partial recourse—for example, due to a partial guarantee by a partner or member of an LLC—the tax impact will vary depending on how the deemed proceeds are allocated to satisfy the debt. Should the proceeds be allocated first to the recourse portion, first to the nonrecourse portion, or pro rata between the two components of the debt? Unfortunately there is little guidance on this issue.
As discussed in greater detail in an article by Lau, Stapleton, and Soltis, “Work Out the Best Tax Consequences for Debt Workouts,” 69 Practical Tax Strategies 68 (August 2002), one source of guidance is Letter Ruling 8348001, in which the IRS held that payments made in satisfaction of a partial recourse debt by the debtor should be allocated first to the nonrecourse portion of the debt. The Service also stated that the tax treatment of the transaction should be consistent with the result under state law. Based on this ruling, the debtor may have the following income tax consequences:
- If the collateral and cash transferred are worth less than the nonrecourse portion of the debt, a gain or loss is realized on the difference between the nonrecourse debt and the sum of cash and the adjusted tax basis of the collateral. COD income is recognized to the extent of the amount of recourse debt.
- If the collateral and cash transferred are worth more than the nonrecourse portion of the debt, gain or loss is realized on the difference between the FMV of the collateral and its adjusted tax basis. COD income is recognized to the extent that the total debt (both recourse and nonrecourse portions) exceeds the sum of cash and the FMV of the collateral. [Lau, Stapleton, and Soltis, “Work Out the Best Tax Consequences for Debt Workouts”]
It is not clear when the debtor guarantees the bottom portion of the debt (bottom guarantee) whether payments must always be allocated first to the nonrecourse portion of the debt. For example, a debtor might be required to honor the guarantee only if the debtor cannot sell the collateral for an amount that is at least equal to the guarantee. In this case, any payment on the debt would apparently satisfy the guarantee amount first.
Income Exclusions Available Under Sec. 108
Under Sec. 61(a)(12), gross income includes income from the discharge of indebtedness. However, Sec. 108 provides several exceptions to income recognition if:
- The discharge occurs in a title 11 case (i.e., bankruptcy);
- The discharge occurs when the taxpayer is insolvent;
- The debt is qualified farm indebtedness; or
- The debt is qualified real property indebtedness.
Any COD income a taxpayer excludes from gross income is applied dollar for dollar to reduce the tax attributes of the taxpayer. Note that if the taxpayer reduces all attributes to zero and any excluded COD income remains, the balance of the COD income goes away. Tax attributes are reduced in the following order according to Sec. 108(b)(2):
- Net operating losses (NOLs) for the tax year of the debt discharge and any NOL carryforwards to that year;
- General business credits under Sec. 38;
- Minimum tax credits under Sec. 53;
- Capital loss carryovers for the tax year of the discharge and any capital loss carryovers to that year;
- Basis reduction: Taxpayers may make an election under Sec. 108(b)(5) to reduce the basis of depreciable property first before reducing other tax attributes; taxpayers making this election must follow a separate set of ordering rules for basis reduction under Sec. 1017; the amount of basis reduction shall not exceed the total adjusted basis of all depreciable property held by the taxpayer as of the beginning of the tax year following the year of discharge;
- Passive activity loss and credit carryovers under Sec. 469(b); and
- Foreign tax credit carryovers under Sec. 27.
In the case of a partnership, the exclusion from gross income under Sec. 108(a), the reduction of tax attributes under Sec. 108(b), and the discharge of qualified real property indebtedness under Sec. 108(c) are applied at the partner level; bankruptcy or insolvency of the partnership rather than the partner is not directly relevant. Each partner makes his or her own determination as to whether to exclude income under Sec. 108 and then makes the corresponding attribute and/or basis reductions.
In the case of a corporation, the provisions of Sec. 108 are applied at the corporate level. For purposes of the basis reduction rules, any losses of an S corporation that may have been disallowed at the shareholder level (for basis or at-risk reasons) and carried forward are treated as NOLs of the corporation for purposes of attribute reduction.
If a taxpayer is neither bankrupt nor insolvent, he or she may still be able to exclude COD income if the debt is qualified real property indebtedness (QRPI). QRPI is debt that was incurred or assumed by the taxpayer in connection with real property used in a trade or business that is secured by such real property and was incurred or assumed before January 1, 1993, or, if incurred or assumed on or after that date, is qualified acquisition indebtedness (Sec. 108(c)(3)). Qualified acquisition indebtedness is debt incurred or assumed to acquire, construct, reconstruct, or substantially improve such property.
The amount of COD income excluded under this provision cannot exceed the excess of the principal of debt over the property’s FMV (Sec. 108(c)(2)(A)). Further, the amount excluded cannot exceed the taxpayer’s aggregate adjusted basis of depreciable property. The amount of COD income excluded is applied to reduce the taxpayer’s basis in real property.
Caution: Rental real estate qualifies for the qualified real property indebtedness exclusion. However, debt secured by land held for investment purposes would not qualify, since it is not held for use in a trade or business. In order to take advantage of predevelopment appreciation at capital gain rates, real estate developers often classify newly acquired land as held for investment before they decide on its ultimate use. A developer should evaluate and weigh classifying property in this manner against the potential of a troubled debt restructuring and the opportunity to use this exception under such a scenario.
Attribute Reduction Planning
In addition to finding the greatest deferral alternative for clients, careful planning requires an analysis of the taxpayer’s tax attributes that may be lost due to the excluded COD income. NOL and capital loss carryforwards are reduced as of the first day of the next tax year. Therefore, taxpayers who are facing attribute reductions should attempt to accelerate income or gains where possible in order to utilize these items before they are lost.
Planning tip: If a taxpayer facing attribute reduction has a significant NOL carryforward and partnership interests with negative capital accounts, the taxpayer should consider triggering the gain on those negative capital accounts in order to use the NOL before it is lost to attribute reduction. The taxpayer could form a wholly owned S corporation and transfer the interest(s) in the partnership(s) to that S corporation. Since the liabilities covering the negative capital would no longer flow through, it would be a constructive distribution resulting in gain recognition.
There are several alternatives available for taxpayers to minimize the current recognition of COD income that could be more beneficial than the method provided for in recent legislation. Careful planning prior to the transaction should involve examining the taxpayer’s solvency situation and tax attributes in order to produce the longest possible deferral.
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.