TAX PLANNING STRATEGIES FOR LOAN WORKOUTS AND REAL ESTATE FORECLOSURES
The economic recession has created problems with commercial real estate loans and in some cases has caused loan defaults. Commercial real estate owners who negotiate with their lenders to reduce their debt and who engage in loan workouts face not only financial and legal issues, but also must consider whether their loan restructuring triggers additional taxes.1 Lenders in the business of lending money are required to report to the IRS a property’s foreclosure or abandonment, and certain lenders are required to report to the IRS a borrower’s discharge of indebtedness income.2
Foreclosure of commercial real estate, whether the property is owned by an individual or through a partnership (or limited liability company), may create a tax loss where the property has a tax basis greater than that property’s debt. On the other hand, where the property’s indebtedness exceeds its tax basis, that property’s foreclosure can create taxable gain and cancellation of indebtedness income. Additionally, when a lender agrees to modify the property’s debt in a loan workout, the borrower will many times realize cancellation of indebtedness income.3 The following discusses the strategies for borrowers to reduce their taxes.
1. The Tax Consequences of the Foreclosure of Real Estate Will Depend on Whether the Promissory Note is Recourse or Nonrecourse .
When real estate is foreclosed upon (or if a deed is given to the lender in lieu of foreclosure), the tax consequences of whether the borrower will be taxed as a “sale” of the real estate or whether the borrower will realize “cancellation of indebtedness income” depends on whether that promissory note is a recourse promissory note or a nonrecourse promissory note. Cancellation of indebtedness income (known as “COD Income”) is taxable to the property owner as ordinary income under Section 61(a)(12), but the property owner/borrower may be able to exclude that COD Income under Section 108. COD Income is not realized for that portion of the foreclosure classified as a “sale” of the real property, and instead the property owner realizes sale and exchange taxable income for this “sale” portion which in turn can generate capital gain to the property owner.
(a) Recourse Promissory Note. When the lender forecloses on real estate secured by a recourse promissory note, the foreclosure is taxed to the borrower/owner in two separate portions. First , there is the “sale” portion where the property owner realizes taxable gain equal to the fair market value of the foreclosed real estate less the owner’s tax basis in that real estate. Second , there is the COD portion which is the amount of the indebtedness which exceeds the fair market value of the real estate.4 This COD Income portion can be tax advantageous to the property owner since COD Income can be excluded from income under Section 108, as described below.
(b) Nonrecourse Promissory Note. Foreclosure of real estate secured by a nonrecourse promissory note means that the lender cannot obtain a judgment against the borrower for that loan’s deficiency amount. Thus, there is no COD Income which can be excluded by the Section 108 provisions. Instead, upon foreclosure (or if a deed is given to the lender in lieu of foreclosure) the borrowing property owner realizes taxable gain as a “sale” equal to the outstanding debt amount less the borrower’s tax basis in the property.5
2. Convert Nonrecourse Debt into Recourse Debt in Order to Be Able to Use One of the Section 108 COD Income Exclusions .
To create COD Income (to which a Section 108 exclusion can then be applied), a property owner could agree to convert that property owner’s nonrecourse debt into recourse debt. However, a property owner may be reluctant to convert its loan into recourse debt if there is a risk of a later deficiency judgment against that property owner.
3. Have the Lender Reduce the Loan Amount in Order to be Able to Use One of the Section 108 COD Income Exclusions.
A property owner may wish to renegotiate with the lender (instead of being taxed as a sale of the property by a foreclosure) to have a reduction in the debt in order to utilize one of the Section 108 COD Income exclusions. A loan reduction (whether that loan is recourse or nonrecourse) will be entirely COD Income. To get the lender to agree to reduce that lender’s debt, the property owner might offer to place a deed in an escrow so that the property will be deeded to the lender at a later date.6 This plan allows the lender to receive the property back without having to go through a foreclosure proceeding, while the borrower (in the form of the debt reduction) realizes COD Income.
4. Utilizing the Bankruptcy or Insolvency Section 108 Exclusions to COD Income .
If the individual borrower/property owner is bankrupt7 or insolvent8 , then the borrower’s COD Income is excluded.9 If the borrower is a partnership, then these two COD Income exclusions apply to the partner if that partner is bankrupt or insolvent , and do not apply at the partnership level. Thus, it is irrelevant if that partnership is in fact insolvent or files for bankruptcy protection.
5. The Borrower Must Reduce its Tax Attributes by the Amount of Excluded COD Income .
If Section 108 bankruptcy or insolvency COD Income exclusions are utilized, then the individual borrower (or partner) must reduce its tax attributes in the following order: Net Operating Losses; general business credits (under Section 38); minimum tax credits (under Section 53); capital losses carryovers; the tax basis in property; passive activity losses and credits carryovers; and foreign tax credit carryovers.10 Importantly, these tax attributes are reduced after the tax year for which the debt discharge is determined and, thus, do not impact the taxpayer’s tax liability for the year of debt discharge.
6. Utilizing the Qualified Real Property Business Indebtedness Exclusion to COD Income .
Forgiveness of debt which was incurred or assumed by the property owner 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.11 The amount excluded cannot exceed the excess, if any, of the outstanding principal of the qualified real property business indebtedness immediately before the discharge over the net fair market value of the qualified real property before the debt discharge.12
The amount of discharged qualified real property business indebtedness which is excluded from income then reduces the tax basis of the taxpayer’s depreciable real property.13 This exclusion is limited to the depreciable basis in all of the taxpayer’s real properties immediately prior to the date that the debt is discharged. Depreciable real property acquired by the taxpayer in contemplation of the debt discharge is not taken into account.14
A disadvantage of electing the qualified real property business indebtedness exclusion is that when the property (which had its tax basis reduced by this election) is ultimately sold, the income caused by that real estate’s lowered tax basis will then be taxed back to the borrower at higher ordinary income rates (rather than at lower long-term capital gains rates).
7. If the Debt is Purchase Money Debt, Then the Borrower Reduces that Debt Without Having to Recognize Taxable Gain .
If the seller of the troubled real property had originally taken back from the buyer/borrower a deed of trust and promissory note (sometimes known as a “purchase money debt”), then to the extent of COD Income triggered by that debt’s reduction that promissory note’s principal amount is reduced tax free to the buyer/borrower under Section 108(e)(5).15
8. Do a Section 1031 Exchange Prior to the Property’s Foreclosure in Order to Avoid Gain Recognition .
A property owner may be faced with the foreclosure of property with a low tax basis and, thus, potential taxable gain. Instead of allowing this property to be foreclosed, the property owner could enter into a Section 1031 tax-free exchange by which the owner exchanges its troubled real estate as relinquished property and receives in the exchange, as replacement property, real estate with equal or more indebtedness. To make this exchange work, the exchanging property owner may have to contribute additional cash to purchase the replacement property, or the third-party buyer purchasing the owner’s troubled relinquished property may have to inject additional cash into this relinquished real property.16
9. A Partnership Can Avoid Taxable Gain from its Troubled Real Estate by Admitting a New Partner to the Partnership in Exchange for that New Partner’s Cash Contribution .
For troubled real estate owned in a partnership, a new cash contributing partner could be admitted to the partnership and the original partners’ percentage interests would then be reduced. The partnership utilizes this newly contributed cash to cure the debt default and to make payments on the loan. 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.17 In order for these 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), the original partners must keep an adequate share of the partnership debt for tax purposes.18
10. Avoid Taxable Gain by Having the Lender Take Back a Partnership Interest in Exchange for that Lender Cancelling the Partnership’s Debt .
The lender may agree to take back a partnership interest in the borrowing partnership in exchange for cancelling the partnership’s debt (recourse or nonrecourse). 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.19
11. Have a Friendly Third Party Acquire the Promissory Note from the Lender .
The property owner can avoid recognizing COD Income by having an unrelated , but friendly, third party acquire the promissory note from the lender.20 To avoid COD Income being generated after the unrelated party acquires the promissory note, there should not be a “significant modification” of that promissory note after that promissory note’s acquisition by the unrelated third party21
12. Creating Deductible Tax Losses from Troubled Real Estate .
Where the tax basis of the foreclosed property is greater than the debt encumbering that property, a tax loss may be realized upon that property’s foreclosure or abandonment. In most cases the property owner will want that tax loss to be an ordinary loss (rather than a capital loss).22
If the taxpayer abandons23 the real property or partnership interest, or if such property or partnership interest is deemed worthless24 , 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, such as if the abandoned or worthless property is not subject to an indebtedness for which there is a foreclosure (or deed in lieu of foreclosure).
Where a partnership interest is abandoned and the partner has a share of the partnership’s liabilities for which that partner is being relieved under the partnership tax rules25 , there will be deemed a partnership distribution to that partner under Section 731, which in turn produces a capital loss (rather than an ordinary loss) to that partner.26 On the other hand, if a partnership interest is worthless or abandoned and the partnership has debt, but that partner has no share of that debt under the partnership tax rules of Section 752, there is no sale or exchange, which then results in an ordinary loss for that partner’s worthless or abandoned partnership interest.
To avoid the limitations on deducting capital losses, if the tax loss recognized on the property’s foreclosure (even if there is a deemed sale of that property) is a Section 1231 loss (rather than a capital loss), then that loss can be offset against the borrower’s ordinary income.27
This Newsletter is not tax or legal advice for any client or matter. Each client’s tax situation contains unique facts. Clients should contact us directly at 310-201-0507 if they require our advice on their specific matter.
1 Single family residential foreclosures and debt relief are governed by special tax rules beyond the scope of this Newsletter. The exclusion for qualified principal residence indebtedness income is governed by §108(a)(1)(E).
2 Lenders in the business of lending money must file a Form 1096 with the IRS and the lender must deliver to the borrower a Form 1099-A when that borrower’s property is abandoned or foreclosed upon. See §6050J. If the borrower has debt discharge income, then the lender, if it is a defined financial entity (such as a financial institution engaged in the business of lending money) must file a Form 1099-C with the IRS. See §6050P.
3 In a loan workout, a debtor can realize discharge of indebtedness 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. See §108(e)(10) and Reg. §1.1001-3.
4 See Reg. §1.1001-2 and Rev. Rul. 90-16.
5 See Reg. §1001-2; and Tufts, 51 AFTR2d 83-1132 (S.Ct. 1983).
6 See Rev. Rule 82-202. The escrow should contain conditions for the deed to be effective in order to avoid IRS arguments that this escrowed deed is a “deed in lieu of foreclosure” and, thus, is sale income and not COD Income. See 2925 Briarpark, 83 AFTR2d 99-312 (5th Cir. 1999).
7 The bankruptcy exclusion applies where these COD Income is discharged in a Title 11 Bankruptcy proceeding, which covers all types of bankruptcies including Chapter 7 and Chapter 11.
8 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. §108(d)(3). Liabilities are determined under financial accounting standards and include contingent liabilities that the borrower by a preponderance of the evidence will probably have to pay in the future. See Merkel, 109 T.C. 463 (1997), aff’d 84 AFTR2d 99-6119 (9th Cir. 1999).
9 See §§108(a)(1)(A) and (B). The amount excluded from income by reason of the borrower’s insolvency may not exceed the amount by which that borrower is insolvent under §108(a)(3).
10 See §§108(b) and 1017.
11 See §§108(a)(1)(D) and 108(c)(3). The property owner must affirmatively make an election on Form 982, attached to the electing taxpayer’s return for the year of debt discharge, in order for the qualified real property business indebtedness exclusion to apply. This exclusion does not apply to C corporations, and does not apply until after the application of the §108 bankruptcy and insolvency exclusions to the COD Income.
12 See §108(c)(2)(A).
13 The basis reduction is of property held at the beginning of the taxable year following the taxable year of the discharge, or when the property is disposed of if earlier. §§1017(a) and 1017(b)(3)(F). For partnerships, the qualified real property business indebtedness exclusion applies at the partner level, even though the determination of whether the debt is qualified real property business indebtedness is made at the partnership level. Each partner decides whether to make the election to exclude their allocable share of COD Income under this exclusion. Each partner’s partnership interest is then treated as depreciable property for purposes of reducing that partner’s basis, and the partnership in turn must reduce the partnership’s basis in depreciable real property with respect to such partner.
14 See Reg. §1.108-6(b).
15 This tax-free exception for purchase money debt applies only if the seller of the real property takes back the debt, and this exception does not apply where a third-party lender (such as a bank) makes the original loan or where the original property’s seller has assigned the debt. The §108(e)(5) rule is mandatory . This rule does not apply where the debt reduction is in a Title 11 (bankruptcy) case or where the property owner/purchaser is insolvent. If the property owner is a partnership, then the insolvency and bankruptcy exceptions are applied at the partner level.
16 One of Section 1031’s requirements is that there must be an “exchange” of the relinquished and replacement properties. If the relinquished property has no equity because that property’s debt exceeds the value of the relinquished property, then there is the tax issue as to whether this §1031 “exchange” requirement has been satisfied.
17 In order for the newly admitted cash partner to not share in the partnership’s assets’ prior appreciation or depreciation in value, the original initial partners’ capital accounts are revalued under §704(b) to their fair market value to reflect unrealized gain or unrealized loss, which would otherwise have been allocated to these initial partners if the property were sold on the date of the new partner’s capital contribution into the partnership.
18 The §752 rules on allocating nonrecourse debt should prevent the original initial partners from being allocated gain under §731. The original partners retain a tax allocation of nonrecourse debt under §752 because they are allocated the 704(c) minimum gain, which in turn allocates to them, initially, most of the nonrecourse debt under the Reg. §1.752-3(a)(2) debt allocation rules. The partnership’s choice of which 704(c) method to utilize will produce different out-of-pocket tax costs and tax benefits to the original initial partners and to the newly admitted partner.
19 See Section 108(e)(8). Prop. 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. COD Income (if any) is recognized at the partnership level and is recognized by those persons that were partners immediately before the COD Income was recognized.
20 The friendly person acquiring the debt will then allow the property owner a longer period of time to cure the debt default. If instead a party “related” to the property owner for tax purposes were to acquire the debt from the lender, then that property owner/debtor would be treated for tax purposes as having acquired its own indebtedness, which in turn would generate COD Income. See §108(e)(4) and Reg. §1.108-2.
21 See Reg. §1.1001-3.
22 Losses are allowed under §165. Capital losses can only be deducted to the extent of capital gains plus $3,000 of ordinary income.
23 Taxpayers to evidence their intention to abandon property or a partnership interest should send out a written notice to the appropriate party (such as the general manager of an LLC) that they intend to abandon and permanently discontinue the use of (and forego all future rights in) the property or partnership interest. See Rev. Rul. 93-80.
24 Property must be evidenced as worthless by a fixed and identifiable event, and by objective facts. See Echols, 68 AFTR 2d 91-5157 (5th Cir., 1991); and Bilthouse, 103 AFTR2d 2009-429 (7th Cir., 2009).
25 See §752.
26 See Rev. Rul. 93-80.
27 See Reg. §1.1231-1(g) Ex. 2. Real estate held for more than one year which is depreciable or used in a trade or business may qualify as a Section 1231 asset.