With remote work models prevailing and many tenants gravitating to Class A buildings with amenities, there are more than a few Class B and Class C property owners with high vacancy rates and significant imminent capital seriously considering giving the keys to their lenders in exchange for relieving the debt obligation.
However, even for properties with a dismal financial outlook, borrowers must consider the potential negative tax consequences of phantom gain and cancellation of debt.
Issue: A lender can force a transfer of title through a foreclosure action and a property owner can transfer the title to a lender voluntarily through a deed-in-lieu of foreclosure. However, either of these transactions is considered a sale of the property for federal and state income tax purposes (and local transfer tax purposes in most jurisdictions).
Under federal tax law, the owner is treated as selling the property for an amount equal to the outstanding debt. When nonrecourse debt is involved, the reported taxable gain would be an amount equal to the debt over the adjusted tax basis in the building.
For buildings owned for a long period of time that have been substantially depreciated (and those acquired more recently as replacement property for older depreciated properties in a like-kind exchange), a property owner could end up recognizing significant taxable gain with no cash proceeds.
By contrast, if recourse debt is involved, surrendering property is treated as two separate transactions for tax purposes, resulting in phantom gain and “cancellation of debt” (“COD”) income. Phantom gain would be realized to the extent that the property’s fair market value (FMV) exceeds the debtor’s adjusted tax basis (sale treatment). COD income would be realized to the extent that the principal amount of the debt exceeds the property’s FMV because that part of the recourse debt has essentially been forgiven (less any amounts paid as part of the recourse obligations).
For example, a debtor transfers an asset with a FMV of $12 million in discharge of $15 million of recourse debt, and the debtor’s tax basis in the asset is $7 million. The debtor will realize $3 million of COD income ($15 million of recourse debt minus FMV of $12 million), and $5 million of phantom gain ($12 FMV of the property less $7 million adjusted tax basis in the property).
With either nonrecourse or recourse debt, the phantom gain is generally taxed at favorable long-term capital gains rates (assuming the property has been held for at least one year).
Solutions: There are very few ways to defer phantom gain.
One possibility is doing a like-kind exchange into a new property. However, an exchange of property with no cash at closing means the owner must find fresh equity to buy a replacement property. Another option is to transfer title in a year when the owner has accumulated losses from other properties to offset any phantom gain.
Cancellation of Debt
Issue: It may be worthwhile to discuss the possibility of reducing or restructuring the debt.
However, if a lender agrees to reduce the outstanding principal balance, the property owner will have to report COD income in an amount equal to the debt reduction. This is the case regardless of whether the debt is nonrecourse or recourse. COD income is taxed at the higher ordinary income rates.
Solutions: Reduction of Basis. A property owner can defer COD income by electing to reduce the basis in the building. This only applies if the debt was used to acquire or improve the building and the debt currently exceeds its fair market value. If the building depreciable basis (land is excluded for this purpose) is not high enough to reduce the entire amount of the COD income, the owner may reduce the depreciable basis of other buildings it owns. Note that this results in lower depreciation deductions in the future, so reducing the depreciable basis in a building effectively amortizes the recognition of the COD income over future years.
Bankruptcy and Insolvency. A borrower that is either insolvent or in bankruptcy can exclude COD income to the extent the borrower is insolvent, or the debt is discharged in bankruptcy. However, the borrower must reduce certain tax “attributes” such as net operating losses, the adjusted tax basis of the building, and other depreciable assets.
COD Income and Partnerships. Since partnerships are considered “pass through” entities, any COD income resulting from restructuring partnership debt is passed through to the partners. Federal tax law requires that to take advantage of the bankruptcy and insolvency rules above, the partners (not the partnership) must be insolvent or receive the discharge in bankruptcy.
The bottom line: understand the tax implications of handing the lender those keys before acting on it. In certain cases, developing a plan with the lender can avert unanticipated, negative tax consequences and help owners maintain control of their properties—a solution both parties can buy into.