Cancellation of Debt Related To Real Estate
In a time when there are a significant number of borrower defaults and debt restructurings, the distinction between recourse debt and nonrecourse debt used to finance property is important. The character of the debt has an effect both on the borrowers’ obligation to the lender and on the tax consequences realized if the debt is cancelled. At the simplest level, the two kinds of debt can be differentiated as follows: Nonrecourse debt is secured by collateral such as real property, but the debtor is not personally liable. If the debtor defaults, the lender’s recovery is limited to the collateral. By contrast, a recourse debt is secured by the collateral and a lender can reach to the personal assets of the borrower in case of default.
WHEN RECOURSE DEBT ISN’T
Although the debt instrument will generally indicate whether a debt is recourse or nonrecourse, in reality the line between recourse and nonrecourse debt is somewhat blurry. Recourse debt can be “limited recourse,” where the borrower is generally liable except for certain specified assets. A carve-out of insignificant assets is not likely to cause recourse debt to be treated as nonrecourse debt. For instance, the personal property of the borrower could be protected via limited recourse. At the other extreme, if the personal liability of a debtor is limited by major carve-outs, then from a tax perspective, the debt may be considered nonrecourse even if it is denoted as recourse in the loan documents. The point at which carve-outs result in a recourse loan crossing the line into nonrecourse will depend on the specific facts and circumstances.
CONSEQUENCES OF FORECLOSURE – THE BASICS
The character of debt has a major bearing on tax consequences if events such as foreclosure, default, or debt modification occur, or if the debt is otherwise forgiven. Based on these tax consequences, there are situations where it is preferable to have recourse debt and other situations where it is preferable to have nonrecourse debt. The discussion immediately below presumes that debt is cancelled and property is conveyed to the lender. Loan modifications and reductions, where property is retained by the debtor, are not addressed here.
When recourse debt is cancelled, the tax results are bifurcated. For instance, in the case where the debt exceeds the fair market value (FMV) of the property, a gain from sale or exchange is recognized to the extent the FMV of the property (considered the amount realized) exceeds basis and then cancellation of debt (COD) income is recognized to the extent the forgiven debt exceeds the FMV of the property.
When nonrecourse liabilities are discharged, there is no bifurcation. Instead, the entire amount of the debt is treated as an amount realized on the sale or exchange of property and no income from the discharge of debt arises.
This simple example illustrates the different results of discharge of recourse versus nonrecourse debt:
Debtor has a loan of $100 on property with a basis of $50 and FMV of $80. The lender forecloses on the property. If the debt is recourse, the result is:
|Gain on sale or exchange||$30|
|FMV of property||(80)|
If the debt is nonrecourse, the result is:
|Gain on sale or exchange||$50|
As mentioned earlier, the type of debt that is preferable depends on the debtor’s circumstances. If the debt is cancelled and the debtor is not insolvent, bankrupt or subject to other COD income exclusions, nonrecourse debt is generally preferable. The debtor will have no COD income, and the gain if any will be long-term (Sec 1231) capital gain if the asset was held for more than one year.
INTERACTION WITH BANKRUPTCY AND INSOLVENCY PROVISIONS
If the debtor is bankrupt or insolvent, the benefits of recourse vs. nonrecourse debt may reverse. In particular, recourse debt may be more desirable, when the assets have declined dramatically in value. Internal Revenue Code (IRC) §108(a)(1)(A) and (B) indicate that when a debtor is bankrupt or insolvent, discharge of indebtedness is excluded from income. The bankruptcy exclusion occurs in Title 11 bankruptcy cases where a taxpayer is under the jurisdiction of a court, and the discharge of debt is granted by the court. In the example above, if the FMV had declined to $50, there would be no gain from sale or exchange (since the amount realized would be equal to the basis), but there would be COD income of $50 (debt of $100 less FMV of $50). All of the COD income would be excluded from income. However, if the bankrupt debtor had nonrecourse debt, the result would be a non-excludable gain from sale or exchange of $50 ($100 debt less basis of $50). There are other debt discharge exclusions available under §108, but they are beyond the scope of this discussion.
The result for cancellation of recourse debt held by insolvent debtors is similar to that for bankrupt debtors except that the exclusion could potentially be limited. The amount of COD excluded from income is limited to the amount by which the taxpayer is insolvent. (Insolvency is defined in IRC §108(d)(3) as the excess of liabilities over the FMV of assets, determined prior to the discharge.) In the example cited in the bankruptcy discussion, if the debtor were insolvent by $30, then $30 of COD would be excluded from income, and $20 would be included. As with the bankruptcy discussion, the result is different for nonrecourse debt. Whether the debtor is insolvent or bankrupt, there will be $50 of non-excludable gain from sale or exchange.
The exclusion of COD from income has a cost. As specified in IRC §108(b), the amount excluded from income must reduce tax attributes. The attributes to reduce include net operating losses, general business credits, capital loss carryforwards, and basis of depreciable property. This attribute reduction can have collateral effects that can result in increases to income recognized and decreases to available credits.
One further note should be made concerning the exclusion of COD from income when the debt is held by an entity rather than by an individual. If the debt is held by an S corporation, insolvency or bankruptcy status is determined at the corporate level. If the entity is a partnership, bankruptcy or insolvency is determined at the partner level. COD that might be excluded from income for some partners could be subject to income inclusion for other partners. Attempts to allocate COD income only to insolvent or bankrupt partners is likely to be found to lack substantial economic effect, and such allocations may be challenged by the IRS.
The above discussion merely hints at the complexities of debt cancellations and restructurings and should not be used as guidance for any specific set of facts and circumstance. For more information, please contact your EisnerAmper professional.