Key Tax Considerations When Acquiring Distressed Real Estate Debt

Due to the ongoing coronavirus pandemic, businesses across a wide variety of industries are facing economic difficulties. Historically, real estate is one such industry that can be susceptible to distress from external market forces. Loans issued to real estate businesses may be subjected to delayed or missed interest and principal payments because of borrowers’ financial circumstances. This distressed real estate debt may, however, present investors with opportunities to buy loans at discounted prices.

As with other economic transactions, the resulting tax implications of acquiring distressed loans need to be considered. Without proper planning and structuring, negative tax impacts may result, including the recognition of phantom tax income where no cash is received but, nevertheless, an investor becomes subject to a tax liability. Expected investment returns, therefore, may be hampered and significantly for real estate debt funds, investors’ IRR expectations may not be met.

Some of the significant tax implications from the acquisition of distressed debt relate to differences between a note’s face amount and the discounted purchase price that exist at the time of a sale or exchange transaction. This difference, which is further defined as a market discount, affects the character of income that investors may recognize in the future upon disposition of a note. Likewise, the difference may result in cancellation of debt income (“COD Income”) to the borrower in certain circumstances where a significant modification of such note occurs. Finally, distressed debt transactions that occur between related parties warrant specific attention due to possible unintended consequences.

Market Discount

The difference between the stated redemption price of note at maturity and the discounted purchase price is defined as the market discount. Market discount is economically accrued over the life of the remaining term of the note. This accrual does not result in taxable income unless an election is made. Upon the redemption or disposition of any note with a market discount, gain is treated as ordinary income to the extent of the accrued market discount on such note. Partial principal payments can also trigger recognition of this ordinary income.

Significant Modifications

There are certain circumstances where unexpected gain could be triggered. If the terms of a note are significantly modified, the note is treated as being exchanged for a new note. Under such an exchange, the lender may have gain or loss recognized based on the difference between the face amount of the new note deemed to be received and the lender’s tax basis in the original note. While this may not impact originators of notes (i.e., the tax basis of the original note would generally match the face amount of the new note if the principal is not modified), investors that purchase distressed debt at a discount will have a lower tax basis. Therefore, if investors acquire debt and shortly thereafter attempt to significantly modify the terms of such debt, unintended tax consequences may occur. Their lower tax basis would create gain for such investors, since the face amount of the new note, absent any discount, may be higher than their tax basis.

This rule generally applies for debt that is considered non-publicly traded. Debt is considered to be publicly traded if (1) during the 31-day period ending 15 days after the issue date there is a sales price for the debt; (2) there are one or more firm quotes for the debt; or (3) there are one or more indicative quotes for the debt. However, a debt instrument will not be treated as being publicly traded if at the time the determination is made the outstanding stated principal amount of the debt instrument does not exceed $100 million.

For publicly traded debt, the gain or loss calculation described previously is based on the fair market value (“FMV”) of the new note rather than the face amount. Therefore, the gain or loss impacts for the lender may be mitigated. However, for the borrower, since the old note is being repaid with a new note of lesser value (e.g., FMV), COD Income may be triggered.

A key determination if changes to a note create the deemed exchange discussed above is whether significant modifications have been made to a note. The concept of a significant modification is defined through the statutes and regulations. A modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.

In making a determination, all modifications to a note are considered collectively so that a series of such modifications may be significant when considered together—although each modification, if considered alone, would not be significant.

Specific rules and guidelines exist for changes in the following:

• Yield
• Timing of payments
• Obligor or security
• The nature of a debt instrument

Related-Party Transactions and Cancellation of Debt Income

Generally, if debt is canceled, forgiven or discharged for less than the outstanding principal, the amount of the canceled debt is taxable and must be reported as taxable income in the year in which the cancellation occurs. Certain exceptions do exist for the taxation of canceled debt.

A sale of a note that is considered non-publicly traded debt by a lender to a third party should generally not result in tax impacts to a borrower if the principal remains the same. However, it should be distinguished that transactions between related parties are closely scrutinized throughout the statutes and regulations due to the possibility of abuse. With distressed debt, transactions between related parties may cause phantom taxable income in certain circumstances, even where a note’s principal remains unchanged and no cash changes hands. Specifically, if a lender sells a note to a related party at a discount, the borrower may be required to recognize the amount of the discount as COD Income, even though the full balance is still owed to the lender. The definition of a related party includes a complex set of relationships as well as attribution rules.

Planning Opportunities

Although the current economic environment may be conducive to investors looking for opportunities with distressed debt, the tax implications of such transactions must be anticipated and planned for. With regard to significant modifications, investors may seek to have sellers of debt attempt to obtain modifications before acquiring the debt. Otherwise, avoiding modifications, which are defined to be significant, may be another viable option for investors.

For related-party transactions and the possibility of COD Income, planning and structuring may be undertaken to eliminate the presence of related parties. Likewise, there are certain exceptions in the statutes and regulations that may prevent taxpayers from having to recognize COD Income. For example, there are certain exceptions to the recognition of COD Income from the discharge of qualified real property business indebtedness.

Due to the complexities surrounding debt transactions—specifically, distressed debt—prior consultation with tax advisers for both the lender and borrower is highly recommended.