With an estimated $1.2 trillion in commercial loans maturing in 2024 and 2025 and office building-backed loans making up 17% of them (according to Guggenheim Partners and Mortgage Bankers Association), it seems inevitable that some borrowers will be involved in loan workouts, looking to renegotiate the terms of their mortgages or, in some cases, turn their properties back to the lender. The financial and emotional toll of such actions can be substantial and exacerbated by the income tax consequences for the unwary borrower.

Tax Implications of COD Income

Internal Revenue Code Section (IRC) 61(a)(11) states the general rule that gross income includes income from discharge of indebtedness, and IRC Section 108 lists the exceptions to this rule — when income from discharge of indebtedness is not included in gross income. Income from discharge of indebtedness, commonly referred to as cancellation of debt (COD) income, can arise in different manners. The most obvious is when a lender writes down the loan amount. For example, a $3 million mortgage the lender reduces to $2.5 million will generate $500,000 of COD income unless an exclusion under IRC Section 108 applies. A debt modification that is considered “significant” — change in interest rate, change in length of loan, etc. — can, to the surprise of many, also generate COD income. A modification is “significant” if the legal rights or obligations are altered, and the degree to which they do are economically significant. A significant modification results in a deemed sale of the loan for a new one, and if the issue price of the “new” loan exceeds the basis in the old loan, COD income will arise.

If, instead of a reduction of the principal of the loan or a modification, the borrower turns back the property to the lender in a foreclosure or deed in lieu of proceeding, the tax consequences are dependent upon whether the loan is recourse or nonrecourse. A recourse loan is one where the borrower is personally liable for the loan, whereas with a nonrecourse loan, no one has a personal liability, and the lender can only go against the property, securing the loan for repayment. (The recourse/nonrecourse distinction is trickier in partnerships/LLCs.) The tax consequences of returning a property to a lender subject to a recourse loan are bifurcated into two components — the amount of the discharged debt over the property’s fair market value (FMV) is COD income and the difference between the FMV and the adjusted basis in the property is treated as a sale generating capital gain or loss. In contrast, the foreclosure of a property secured by a nonrecourse loan does not generate COD income. The difference between the amount of the discharged debt and the adjusted basis in the property is treated as a sale generating capital gain or loss. The FMV of the property at the time of the discharge is ignored. A foreclosure of a recourse and nonrecourse loan results in the same total amount of income, but the components of the income differ, as seen in the following example:

Example: The FMV of the property is $4.15 million, the outstanding mortgage is $4.4 million, and the adjusted basis of the property is $4 million. If the mortgage is recourse, the taxpayer would have a COD income of $250,000 (O/S loan of $4.4 million over FMV of $4.15 million and a gain on sale of $150,000 (FMV of $4.15 million over the adjusted basis of $4 million.)If, instead, the mortgage is nonrecourse, the borrower would have a gain of $400,000 (O/S loan of $4.4 million over the adjusted basis of $4 million) with no COD income.

Methods to Defer the Taxability of COD Income

The gain portion from a foreclosure or deed in lieu can be deferred in a Section 1031 exchange. A borrower desiring to execute a 1031 exchange in this situation must adhere to the normal Section 1031 timelines and requirements, including transferring title to the property to an exchange accommodator before the property is foreclosed upon.

As mentioned above, IRC Section 108 provides exclusions to the recognition of COD income. The most significant exclusions are (1) if the borrower is bankrupt, (2) if the borrower is insolvent, (3) if the debt represents seller financing, or (4) if the debt was used to acquire, construct or substantially improve real property securing the debt and is used in the borrower’s trade or business. Note that if the borrower is a partnership or LLC, the bankruptcy and insolvency exceptions are tested at the partner level, whereas if the borrower is a corporation — a Subchapter C or S corporation — bankruptcy is measured at the corporate level. Testing bankruptcy and insolvency at the partner level limits partnerships and LLCs ability to use these two exceptions.

The price one pays for using the IRC Section 108 exclusions is the borrower must reduce tax attributes in the following order (1) net operating losses (NOL) carryovers, (2) general business tax credit, (3) minimum tax credit, (4) capital loss carryovers, (5) basis in property, (6) passive loss carryovers, and (7) foreign tax credit carryovers. The taxpayer may elect instead to reduce the basis of depreciable property before reducing these tax attributes. This may be useful for a taxpayer with long-life real property who would rather forego depreciation over many years than lose an NOL that can be used immediately. These reductions will increase future years’ income making the IRC Section 108 benefits a deferral of income rather than a permanent exclusion. Nevertheless, these deferrals can be valuable for a financially distressed taxpayer. The amount of COD and tax attributes reduced are reported on Form 982 in a borrower’s income tax return.

The tax consequences from a loan workout are complex, and proper planning can improve the outcome. For this reason, consulting a tax advisor with knowledge in this area is particularly important.

This article was contributed by Paul Rosenkranz, CPA, MST, Managing Director, CBIZ MHM, LLC