It’s no surprise that Covid-19 has had a dramatic impact on the commercial real estate industry. Building owners feel the effects in two ways: Tenants are strapped for cash, and employees are working from home. Despite various state and local grants that have recently become available, property owners find themselves working with tenants on rent deferrals or abatements, early lease terminations, or modifications to reduce existing space. The result is a devaluation of commercial real estate that’s left owners overleveraged and unable to pay their debt.
When restructuring a debt, taxpayers may find themselves in a position where they are forced to recognize income for tax purposes. They may encounter a discharge of indebtedness income, also known as cancellation-of-debt income or a gain or loss resulting from a sale. Treatment of COD income for federal income taxes will depend on the classification of the taxpayer receiving debt forgiveness. In addition, states may vary in how they tax COD income. They should be looked at separately.
For corporations, including S-corporations, COD income can be excluded from gross income for federal income tax purposes if the debt is discharged in Chapter 11 bankruptcy. In addition, corporations that are merely insolvent immediately before a discharge—having liabilities in excess of the fair market value of assets—can exclude COD income to the extent of their insolvency.
Taxpayers that choose to exclude COD as a result of bankruptcy or insolvency are required to reduce tax attributes. Unless the taxpayer elects otherwise, the tax attributes are required to be reduced by the amount of debt discharged in the following order:
• net operating losses,
• general business credits,
• minimum tax credits,
• capital loss carryforwards,
• basis reduction of property,
• passive activity losses and credit carryovers, and
• foreign tax credit carryovers.
For partnerships, either the bankruptcy or insolvency analysis or both are performed at the partner level, so while the entity may be insolvent, the individuals or trusts who are the ultimate owners of the entity may not be. The exception is determined on a partner-by-partner basis, so a situation could occur in which one partner is insolvent and will not be taxed on the income while another partner is solvent and will have to pay federal income tax on the COD income.
Similar to corporations, the partner in the partnership who excludes COD income because of insolvency must reduce personal tax attributes to the extent available.
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‘Qualified real property business indebtedness’
While the insolvency exception is passed through to the partner in many cases, taxpayers, other than C-corporations, have an opportunity to exclude COD income generated from “qualified real property business indebtedness” at the entity level. This exception only applies to debt incurred in connection with and secured by real property used in a trade or business. For partnerships, disregarded entities and grantor trusts, the income exclusion and election are reported at the partner level. Conversely, the determination of whether the indebtedness is qualified real property business indebtedness is determined at the partnership level.
The following criteria must be met for debt to be considered qualified real property business indebtedness:
• The real property must be held by the partnership in connection with a trade or business conducted by the partnership.A rental arrangement under a triple net lease may not qualify as a trade or business.
• The indebtedness was incurred or assumed to acquire, construct, reconstruct or substantially improve the real property.
• The partner must make a timely election on the personal income tax return by filing Form 982.
The amount of COD income from qualified real property business indebtedness is determined at the partnership level. It is limited to the excess of the outstanding principal amount of the indebtedness immediately before the discharge over the fair market value of the real property reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property. Once the amount is determined, the election is made by filing Form 982 with the partner’s income tax return combined with reducing the basis of the partner’s interest in the partnership by the amount of COD income excluded and the basis of the real property is reduced on the following year’s tax return.
In a foreclosure, whether voluntarily (deed in lieu) or involuntarily, the lender takes title to the collateralized property to satisfy the outstanding debt. The transaction is generally considered a sale of property, but the tax treatment is also dependent on whether the debt is recourse or nonrecourse.
When a foreclosure occurs on nonrecourse debt, the outstanding principal debt balance canceled is included in the proceeds on the property disposition. Gain or loss is characterized as either Section 1231 gain when business property, subject to depreciation recapture, or capital gain when investment property. The gain may also be subject to the depreciation recapture rules under Section 1250. The fair market value of the property has no impact on the amount realized for income tax purposes.
Similarly, when dealing with recourse debt, the same rules generally apply, except when the recourse debt exceeds the FMV of the surrendered property. In this case, the transaction is considered two unrelated transactions where the taxpayer may be required to recognize ordinary income and capital gain or loss. First, the taxpayer will recognize COD income to the extent the canceled debt exceeds the FMV of the property at the time of the foreclosure. Second, a sale or exchange is deemed to occur, and gain or loss will be determined by calculating the difference between the amount realized (the canceled debt less the portion treated as COD income) and the adjusted tax basis of the property. In situations where the property’s FMV is less than its adjusted tax basis, a taxpayer may realize a capital loss (ordinary loss if the underlying collateral was Section 1231 property) and COD income on the same transaction. This would result in a net effect of the same total gain or loss that would have occurred if the property was secured by nonrecourse debt.
There are several strategies to restructure, modify or eliminate liabilities that can reduce the adverse federal and state income tax consequences of COD income that are dependent on individual facts and circumstances.
We are here to work with you to find the best approach for you and your business. Please contact your Citrin Cooperman professional today to find out more.
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