Debt Modification and Cancellation: What Real Estate Professionals Should Consider

Four years since the start of the COVID-19 pandemic, commercial real estate operators and developers are still feeling pressure from steadily rising interest rates, looming debt maturities and increasing vacancy rates. Some parties may have to consider walking away from the investment or seeking debt modification opportunities until market conditions become more favorable. When debt is involved, there may be different tax consequences based on the situation and course of action. Below, we consider the tax implications for different debt cancellations and debt modifications.

Cancellation of Debt (COD) Income. When a lender forgives or cancels a portion of your debt, the IRS generally considers the forgiven amount taxable income. However, exceptions and exclusions, such as insolvency or bankruptcy, may allow you to exclude COD income from your taxable income. Knowing when and how these exceptions apply can save you from significant tax burdens. If the taxpayer is not a corporation and is not considered bankrupt or insolvent, they may find relief under the Qualified Real Property Business Indebtedness (QRPBI) exception.

There is a tradeoff to excluding taxable income under these exceptions. For the bankruptcy or insolvency exception, there may need to be a reduction to net operating losses, tax credits, capital loss carryovers or other tax attribute items. If a taxpayer elects to apply the qualified real property indebtedness exclusion, the taxpayer must reduce their tax basis in depreciable real property. Consequently, excluding COD income under one of these exceptions may only result in a tax deferral instead of a complete exclusion from taxation.

Debt Modifications. When the taxpayer, as the debtor, modifies the terms of the debt, they may treat it as an exchange for a new debt issuance. This deemed exchange may result in the recognition of COD Income. There are two questions that taxpayers need to answer to determine what the resulting tax and accounting consequences may be:

• Has a debt modification occurred?
• Is the modification significant?

If a modification includes a change in the yield, payment timing, obliger or security, nature of the debt instrument, accounting or financial covenants, or other factors, the taxpayer should complete further analysis to determine what the associated tax consequences may be.

Foreclosure of Real Property. A foreclosure is a legal process that allows a lender to seize collateral property to recover outstanding mortgage debt. A deed-in-lieu of foreclosure is an arrangement where the borrower voluntarily turns over ownership of the property to the lender to avoid the foreclosure process. Both transactions are treated as a sale or exchange for tax purposes, but there may be nuances to the tax treatment based on a few different factors. These factors include whether the debt is recourse or nonrecourse, if there is discharged principal and interest, the adjusted basis in the property at the time of foreclosure, and the character of the underlying property as ordinary versus capital.

Abandonment of Real Property. An abandonment occurs when the taxpayer voluntarily and permanently gives up possession and use of the property with the intention of ending the ownership but not pass it on to someone else. A voluntary conveyance of the property in lieu of foreclosure is not considered an abandonment and follows the above foreclosure treatment. The tax consequences of abandonment are similar to foreclosure, but the timing of recognition may depend on whether the debt is recourse or nonrecourse.

There may also be situations where a partner in a partnership that holds real property may decide to abandon their partnership interest. The partner should notify the partnership and follow all the necessary steps to establish the intention to abandon the interest and an affirmative act of abandonment. The character of the abandonment may depend on the facts and circumstances, including but not limited to, whether there was a decrease in the partner’s share of liabilities as a result of the abandonment.

Every real estate debt restructuring situation is unique, and the tax implications can be complex. At Moore Colson, we specialize in helping real estate professionals understand and manage these challenges. Contact us for personalized advice and strategies tailored to your specific circumstances.