Editor: Anthony S. Bakale, CPA
As the pandemic recedes, many economists are predicting a shift in the commercial real estate sector. The anticipation is that many companies will continue to work remotely for the foreseeable future and perhaps even shrink their office footprint, which may dry up the demand for office space and force landlords and banks to renegotiate debt agreements or, worse, foreclose on assets. These renegotiations or foreclosures could have significant tax consequences.
During discussions with a bank, it is important to keep in mind that the guarantees on the debt could have a significant impact on the tax cost of the foreclosure. That tax cost needs to be considered when assessing the assets' future in the investor's portfolio. When a loan is foreclosed, the tax consequences for investors depend partly on the distinction between recourse debt (where the lender has a right to seek judgment against the borrower's and guarantor's personal assets if the loan is not repaid) and nonrecourse debt (where no personal assets are on the line).
Nonrecourse debt: If the debt is considered nonrecourse debt, the Supreme Court's Tufts decision (461 U.S. 300 (1983)) resolved the main issue regarding the tax treatment of a foreclosure (or deed-in-lieu-of-foreclosure) transaction. Such a transaction is treated as a deemed sale by the borrower to the lender with proceeds equal to the nonrecourse debt. Consequently, no debt discharge income results. A 1988 federal appeals court decision (Allan, 856 F.2d 1169 (8th Cir. 1988)) concluded the amount realized on the deemed sale includes the full amount of the nonrecourse debt plus any additions to principal for items (e.g., accrued interest) that generated ordinary deductions for the borrower.
Although there is no debt discharge income, the calculation of the gain or loss on the deemed sale will have a tax impact on the investors. In many situations, because of prior depreciation deductions that exceeded the debt repayment schedule, an investor will have gain on the deemed sale that results in a tax cost to the investor without any cash flow being generated from the foreclosure. It should be noted that in cases where prior depreciation deductions were not utilized on an individual's tax return due to passive activity loss limitations or other individual tax situations, the gain may be reduced or eliminated entirely. Accordingly, during planning, a practitioner should pay close attention to investors' personal tax attributes if the real estate is held in a passthrough entity.
Recourse debt: If a debt is recourse, personal assets are on the line. Unlike the treatment of nonrecourse debt, a foreclosure involving recourse debt may result in debt discharge income. The lender's acquisition of the property in satisfaction of the recourse debt is treated as a deemed sale with proceeds equal to the lesser of the fair market value (FMV) of the property at foreclosure or the amount of the secured debt. If the amount of the debt exceeds the FMV, the difference is treated as debt discharge income if it is forgiven (Regs. Sec. 1.1001-2). At the same time, the calculation of income can result in a calculated gain or a loss depending on the tax basis of the property as compared to the FMV.
Note that debt discharge income occurs upon a foreclosure transaction only if the lender discharges all debt upon taking the property securing the debt. If the lender continues to pursue the debtor or guarantor for any deficiency (excess of the debt over the property's FMV), debt discharge income does not occur until that deficiency is discharged for less than full value.
It is possible for a foreclosure transaction involving recourse debt to result in both a capital loss (because the FMV is less than the basis) and debt discharge income (because the secured debt exceeds the property's FMV). Again, attention must be paid to the investors' tax situation, and attributes must be considered since the resulting income or loss may have a negative cash impact on investors even if they are not required to make debt payments.
Restructuring and reduction in debt amount
The restructuring and reduction of outstanding debt will result in debt discharge income allocable to a property's owners/investors. This debt discharge income, whether the debt reduction involves a recourse or a nonrecourse obligation, is treated as ordinary income on a property's owner's return. However, as discussed in the next subsection, there are opportunities under Sec. 108 that will enable an investor to exclude this income from tax. These opportunities should be reviewed while considering the tax impact of either a debt restructuring or a foreclosure transaction that would generate taxable income.
Sec. 108 planning
Sec. 108, which concerns income from discharge of indebtedness, states that gross income does not include any amount that would be includible in gross income by reason of the discharge (in whole or part) of indebtedness of the taxpayer if the discharge occurs:
- In a Title 11 bankruptcy case;
- When the taxpayer is insolvent;
- When the indebtedness discharged is qualified farm indebtedness;
- If the taxpayer is not a C corporation and the indebtedness discharged is qualified real property business indebtedness; or
- The indebtedness discharged is qualified principal residence indebtedness that is discharged or subject to a written arrangement before Jan. 1, 2026.
The coordination of these discharge opportunities is straightforward. Work down the list, and the first one to apply takes precedence. As such, a situation where a taxpayer is involved in a Title 11 bankruptcy case and thus qualifies for exclusion is often fairly straightforward. Be aware, however, that along with all of the opportunities to exclude the cancellation-of-debt (COD) income, Sec. 108 usually requires that the amount excluded from income reduce the taxpayer's applicable favorable tax attributes, including net operating losses, unused business credits, minimum tax credits, net capital losses, basis of property, passive activity loss carryforwards and credit carryovers, and foreign tax credit carryovers (Regs. Sec. 1.108-7). However, the taxpayer may elect to first reduce the basis in depreciable property under Sec. 108(b)(5) and then reduce any remaining tax attributes by any excess amount.
The exclusion because of insolvency is more nuanced. In general, the insolvency exemption applies to taxpayers whose liabilities exceed the FMV of their assets (Sec. 108(d)(3)). The key word in the previous sentence is "taxpayer." For purposes of Sec. 108, a taxpayer is an individual, a C corporation, or an S corporation. However, a partnership is not considered a taxpayer under Sec. 108; instead, the debt discharge income is passed out to the partner, and the partner must determine if the insolvency exclusion applies.
This is one of the rare cases where holding real estate in an S corporation may be more beneficial than holding it in a partnership. Planning for the COD income and moving the real estate into an S corporation may cause gain recognition under Sec. 357(c) for the liabilities in excess of the tax basis. It is also possible that the transaction could be viewed simply as a tax-avoidance scheme to not recognize the COD income under the sham-transaction doctrine.
The other common COD exclusion provision for real estate companies is an indebtedness discharge related to qualified real property business indebtedness. The term "qualified real property business indebtedness" is defined in Sec. 108(c)(3). To meet the definition, the indebtedness must be connected with real property used in a trade or business that is secured by the property. It must also be acquisition indebtedness if incurred or assumed after Jan. 1, 1993. In the case of property owned by a partnership, the determination of whether the debt is qualified real property indebtedness is made at the partnership level.
If the exclusion applies, Sec. 108(c) states that the amount excluded shall reduce the basis of the depreciable real property of the taxpayer pursuant to the provision of Sec. 1017, meaning the partner elects to reduce his or her proportionate share of the basis in real property. The regulations under Sec. 1017 state that the basis of the property that the debt cancellation is attributable to should first be reduced. However, the regulations under Sec. 108 state that the partnership that receives the debt discharge is not required to consent to the reduction in basis of the attributable asset unless it is requested by five or fewer partners owning an aggregate of more than 50% of the capital and profits interest in the partnership or if consent is requested by partners owning an aggregate of more than 80% of the capital and profits interest in the partnership.
If the partnership does not agree to the reduction in basis of assets, the partner can still exclude the income by electing to reduce the basis of other depreciable real property owned directly or indirectly by the partner. If the property incurring the debt reduction is still at risk of foreclosure, the approach to reduce other property basis may be preferable to avoid recognition of the gain related to the foreclosed property's reduced basis.
It is important for real property managers, developers, and investors to consider the tax impact of debt workouts and potential foreclosures. While it is not always possible to eliminate negative tax implications of foreclosures and debt modifications, there are opportunities to do so.
Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.