Negative cash flows, high vacancy rates, environmental and geographic concerns and other macroeconomic factors are all risks, and, therefore, reasons why real estate owners may experience operating distress. Furthermore, real estate owners commonly finance the acquisition of properties with debt, which comes along with various debt covenants, restrictions and debt service requirements. As a result of a lack of viability for servicing debt and/or where the fair market value of real property decreases below the remaining balance of debt, real estate owners need to review potential options and outcomes, including the harsh potential of a foreclosure.
In addition to analyzing the economics of a distressed position, real estate owners must consider the tax implications of the various outcomes surrounding debt. In the worst-case scenario of a foreclosure, not only can an owner lose a property, but also be subject to income tax on phantom income.
There are various outcomes relating to debt for a real estate owner in distress. A lender may agree to a reduction of the principal balance of the debt or alternatively allow a borrower to settle the debt at a discount. In other cases, a lender may allow for a debt workout whereby the terms of the debt are modified. In each of these first three scenarios, the real estate owner retains the property. In other scenarios, a real estate owner unfortunately loses the property. A real estate owner may look to sell the asset in a fire sale in order to satisfy the debt balance without going through a foreclosure transaction or alternatively may give up the property in a deed-in-lieu of foreclosure transaction. Ultimately without a satisfactory negotiation result, a lender may foreclose on the loan and force a sale of the asset.
Key factors and definitions
Each of the distress scenarios have tax implications that need to be considered and are discussed in the tables below, which separate the scenarios between when an owner is able to retain the real property vs. when the real property is disposed of. Several key factors and definitions need to be understood prior to considering the tax implications of a given scenario:
• Solvency: A taxpayer’s status of solvent or insolvent is determined by comparing the taxpayer’s liabilities and assets (at fair market value) immediately prior to discharge of a debt. A taxpayer is deemed insolvent to the extent the taxpayer’s liabilities exceed the value of assets. For non-recourse debt that exceeds the fair market value of property, only the amount of debt actually discharged (in addition to the amount of debt equal to fair market value) is factored into the insolvency computation. If debt is held by a partnership, the solvency factor and availability of exclusions, discussed later, are generally determined at the partner level rather than the partnership level.
• Fair market value: The Supreme Court in United States v. Cartwright, 411 U.S. 546 (1973), as well as Treasury Regulation § 1.170A-1(c)(2) both provide that the fair market value of property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Furthermore, “the determination of fair market value is a question of fact, and the trier of fact must weigh all relevant evidence and draw appropriate inferences.” Estate of Adell v. Comm’r of Internal Revenue, 108 T.C.M. (CCH) 107 (2014) (citing Comm’r v. Scottish Am. Inv. Co., 323 U.S. 119 (1944)). For foreclosure transactions, guidance exists that the sale price of property at a foreclosure sale is presumed to be its fair market value, absent clear and convincing proof to the contrary.
• Reduction of tax attributes: Certain exclusions of income from the discharge of debt, discussed later, require that a taxpayer reduce certain tax attributes, thereby deferring the recognition of income to a later date. The taxpayer’s attributes are reduced in the following order: (1) net operating losses, (2) general business credit, (3) minimum tax credit, (4) capital loss carryovers, (5) basis of property, (6) passive activity loss and credit carryovers and (7) foreign tax credit carryovers. Alternatively, a taxpayer may elect to first reduce the basis of the taxpayer’s depreciable property.
• Non-recourse vs. recourse debt: For discharge of indebtedness purposes, the classification of a discharged debt as non-recourse or recourse is a significant factor as the type and amount of income a taxpayer recognizes is directly affected. A debt is classified as recourse if a lender can reach all of the taxpayer’s assets. A debt is classified as nonrecourse if the lender’s sole recourse is against the collateral subject to the debt.
The rules for classifying debt as non-recourse vs. recourse for purposes of debt allocations to partners in a partnership are different than those rules for classifying debt as non-recourse vs. recourse for the discharge of indebtedness rules. For example, although the partners of a partnership may not be treated as having recourse debt on their K-1s from a partnership (i.e., because of no personal liability), the debt may still be considered recourse to the partnership for discharge of indebtedness purposes if the lender can go after any of the partnership’s assets.
Real estate structures are commonly set up to include special purpose entities as the property owning and/or borrowing entities which are disregarded for federal tax purposes in that they are wholly owned by a parent holding entity which is regarded for tax purposes. In regard to debt owned by a disregarded entity, even though such debt may be recourse at the disregarded entity level where a lender could reach all of the disregarded entity’s assets, the IRS has ruled on multiple occasions that such debt is non-recourse with respect to the regarded parent entity since the lender can only go after a specified subset of assets (i.e., the disregarded entity’s assets).
In general, the non-recourse vs. recourse determination is highly based on facts and circumstances and there are differing interpretations on the topic. For example, case guidance exists discussing debt where a lender could go after all of a partnership’s assets; however, the terms of the partnership’s agreement would have prohibited the partnership from acquiring any additional assets that would not be subject as collateral of debt. While the court in Great Plains Gasification Assocs. v. Commissioner, 92 T.C.M. (CCH) 534 (2006) found this fact to being supportive of the determination that such debt would be characterized as nonrecourse, the IRS subsequently questioned several findings of the case and left open uncertainty regarding how much reliance could be placed on the case.
• Qualified real property business indebtedness (“QRPBI”): Discharge of indebtedness income relating to QRPBI may be eligible for exclusion under certain circumstances. QRPBI is defined as indebtedness that meets three requirements: 1) incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property, 2) incurred or assumed before January 1, 1993, or if incurred or assumed on or after such date, is qualified acquisition indebtedness, and (3) is subject to an election made by the taxpayer to have the exclusion for such debt apply.
Real Estate Debt Scenarios and Tax Implications
|Scenarios where real property is retained|
|Lender reduces principal balance or agrees to settle debt at a discount||Solvent taxpayer : Discharge of indebtedness income is recognized as ordinary income by solvent taxpayers.
However, if the discharge of indebtedness income relates to QRPBI, some, or all, of such income may be excluded from income, subject to two limitations:
1. The exclusion cannot exceed the excess of the debt immediately before the discharge over the real property’s net fair market value at such time. Net fair market value means the fair market value of the qualifying real property, reduced by the outstanding principal amount of any QRPBI (other than the discharged indebtedness) that is secured by such property immediately before and after the discharge.
Note that this rule operates in a manner so as to prohibit the creation of equity in real estate tax free. For example, if the fair market value of property is $1,000,000 with debt of $1,200,000, the exclusion would apply against up to $200,000 of income (whereby fair market value would then equal debt). If any additional exclusion were allowed, equity would be created (i.e., if $300,000 is discharged, the taxpayer would then have $100,000 of equity: $1,000,000 of fair value less $900,000 of debt).
2. Furthermore, the amount excluded cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge (after reduction for any depreciation claimed during the year as well as any basis adjustments under the insolvent tax attribute reduction rules).
The amount excluded from gross income under the QRBI rules reduces the basis of the depreciable real property of the taxpayer.
For partnerships that own real property with QRPBI, while the determination of QRPBI and fair market value limitations are applied at the partnership level, the election to have the exclusion apply is made at the partner level and furthermore the exclusion from income applies at the partner level. Correspondingly, a partner must consider the basis reduction that is required. To that end, any interest of a partner in a partnership will be treated as depreciable real property to the extent of such partner’s proportionate interest in the depreciable real property held by such partnership. Furthermore, a corresponding reduction in the partnership’s basis in depreciable real property with respect to such partner is made.
|Insolvent taxpayer : The tax outcome for insolvent taxpayers depends on whether a bankruptcy scenario exists. For insolvent taxpayers not in bankruptcy, the discharged amount of debt is bifurcated into two buckets.
1. The first bucket consists of an amount of discharge which is eligible to be excluded from income subject to a limitation equal to the amount by which the taxpayer is insolvent (i.e., excess of liabilities over fair market value of assets, immediately before discharge). Tax attributes of the taxpayer need to be reduced equal to the exclusion amount (effectively deferring the recognition of the income).
For taxpayers in a bankruptcy case, the entire amount of debt discharged is subject to exclusion; however, tax attributes of the taxpayer need to be reduced (effectively deferring the recognition of the income).
|Special rule for purchase money mortgages : If the seller of the property was the lender at the time of purchase, and the seller continues to be the holder of the debt, the reduction of debt is treated as a purchase price adjustment if the taxpayer is solvent. This option is generally not applicable for insolvency or bankruptcy scenarios.
Note that unlike the general exclusion rules which apply at the partner level, the exclusion for purchase money mortgages applies at the partnership level. Furthermore, for real property and debt held by a partnership, the insolvency or bankruptcy status of a partnership is disregarded. The IRS has stated it will not challenge the purchase price adjustment at the partnership level if all other requirements are met (i.e., other than the insolvency / bankruptcy status).
|Lender and borrower agree to a debt workout (i.e., modifications to terms of debt)||The general theory surrounding debt workouts / modifications is that a modification to a debt is significant enough that the borrower is deemed to issue a new debt instrument in exchange for the existing debt. The issue price of such new instrument is treated as an amount of money which satisfies the existing debt. If this deemed amount of money is less than the existing debt, discharge of indebtedness income results for the taxpayer. Note that a pure reduction of the principal balance of debt is from the outset discharge of indebtedness income as discussed earlier.
Two key requirements need to be met in order for a deemed exchange to occur under the debt modification rules.
1. A modification needs to exist. In general, a modification means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument.
Some examples of modifications that are not significant modifications are the following:
1. A modification that adds, deletes, or alters customary accounting or financial covenants.
2. A temporary forbearance from collection efforts or acceleration clauses by a lender for a period up to two years plus any additional period of good faith negotiations.
|Scenarios where real property is disposed of|
|Real estate owner sells real property or lender forecloses and forces a sale of real property||Normal gain or loss rules apply relating to sales of property. The gain from the sale of property is the excess of the amount realized over the adjusted basis. If instead there is an excess of adjusted basis over the amount realized, there is a loss on the sale of the property. The sale of real property used in a trade or business is generally treated as Section 1231 gain or loss.
Amount realized from a sale includes cash and the FMV of any property received in the transaction. If there is sufficient cash to pay off the debt on the property, the transaction is treated like any other disposition of property.
If sales proceeds are insufficient to pay off all debt and the lender discharges any remaining balance, such discharged amount is added to the amount realized if such debt is considered nonrecourse debt and therefore would factor into the gain or loss computation.
For recourse debt, any discharged amount would be treated as discharge of indebtedness income similar to any other discharge income which would be ordinary income; however, subject to the insolvency and bankruptcy exclusions described above.
|Real estate owner transfers real property to lender in satisfaction of debt in a deed-in-lieu of foreclosure transaction||The transaction is treated as a sale of property where the amount realized is equal to the amount of the debt which is satisfied by the transfer. The difference between the amount realized and the adjusted basis of the property produces gain or loss on the disposition. The sale of real property used in a trade or business is generally treated as Section 1231 gain or loss.
If the debt is nonrecourse debt, the entire amount of the debt is treated as the amount realized.
If the debt is recourse debt and such debt exceeds the fair market value of the property, the transaction is bifurcated into two transactions. The fair market value of the property is the amount realized for purposes of determining the gain or loss on the deemed sale of the property. The excess of the recourse debt over the fair market value of the property is treated as discharge of indebtedness income which is ordinary income, however subject to the insolvency and bankruptcy exclusions described above.
Other considerations and next steps
As noted in the scenarios above, a deemed sale occurs in most scenarios where real property is transferred voluntarily or involuntarily in satisfaction of debt. Typical recapture and recharacterization rules therefore apply in such transactions. For example, ordinary income recapture for accelerated depreciation, as well as unrecaptured 1250 gain characterization, apply in such cases.
In determining the amount of an unpaid mortgage, unpaid interest is included as part of the amount realized on the discharge of debt. Thereby, for non-recourse debt, this additional amount realized affects the amount of Section 1231 gain or loss on disposition. For recourse debt where the total debt is greater than the fair market value of the property, additional discharge of indebtedness ordinary income is recognized.
As a result of the various nuances involved with distressed real estate and the related debt, careful planning and analysis are required to achieve the most tax efficient results. The loss of a real estate property can be economically devastating, however the possibility of phantom taxable income on top of such loss can create even more economic hardship. A detailed review of the potential workout options with a lender, the non-recourse vs. recourse nature of the debt, solvency of the owner and/or partners of a partnership and analysis of potential exclusions are all important steps when dealing with any distressed real estate scenario. As a result, consultation with a tax advisor is highly recommended.