Foreclosures and Debt Restructuring – The Tax Implications

The COVID-19 pandemic and resulting economic slowdown have had significant adverse effects on the real estate sector. State-mandated protective orders have significantly reduced business operations at most of the country’s physical workplaces including retail, office, and hospitality locations. Businesses are having to make financial decisions and allocate available cash in light of significantly reduced revenues. Many tenants, especially those forced to close for some period of time, have requested rent reductions or forbearance.

In response to the financial hardships caused by the pandemic, many states and local jurisdictions issued moratoriums on residential and commercial evictions. These extraordinary times and orders have left landlords and property owners nationwide in a situation where they are unable to collect rent from their tenants or are only able to collect reduced rent while still being obligated to pay the existing debt service on their properties. 

Like any business, cash flow is imperative for real estate ownership to continue. Without the ability to collect rent on tenant leases, the real estate lessor is in danger of borrower default on its debt obligations and potential foreclosure or debt restructuring on its properties.   The following will discuss the tax implications of foreclosure and debt restructuring and potential exclusions taxpayers may be able to utilize.

Consequences of Foreclosure

Foreclosure is the action of taking possession of a mortgaged property when the mortgagor fails to keep up its mortgage payments. For tax purposes, a foreclosure is recognized as a taxable sale or exchange with the character of the debt involved (recourse or nonrecourse) dictating the specific tax treatment.

Debt is considered nonrecourse to the extent no mortgagor bears the economic risk of loss linked with such liability. Recourse debt occurs when a mortgagor does bear the economic risk linked with such liability.

When recourse debt is cancelled in foreclosure, the tax results are bifurcated. 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 the basis, and then cancellation of debt (COD) income is recognized to the extent the forgiven debt exceeds the FMV of the property.

In the instance of a foreclosure involving nonrecourse debt, there is no bifurcation. The entire amount of the debt is treated as an amount realized on the sale or exchange of the property and no income from discharge of debt arises. The amount realized will never be less than the outstanding debt principal amount at the time of foreclosure even where the FMV of the foreclosed property is less than the outstanding nonrecourse debt.

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 (IRC Sec. 1231) capital gain if the asset was held for more than one year.

Exclusion of Income and Interaction with Bankruptcy and Insolvency Provisions

As discussed, taxpayers can realize two types of income in foreclosure or debt restructuring.  Gain or loss may be realized on the sale of the property and, depending on the type of debt discharged, there may be cancellation of debt (COD) income.

Amounts by which taxpayers benefit from the discharge of indebtedness is generally included in their gross income.  However, IRC Sec. 108(a)(1) indicates that when a debtor is bankrupt or insolvent, discharge of indebtedness is excluded from income. So, 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 as realized COD income would be excludable. If the bankrupt debtor had nonrecourse debt, the result would be non-excludable gain from sale or exchange.

The result from cancellation of recourse debt held by insolvent debtors is similar to that for bankrupt debtors except that the exclusion could be potentially limited. The amount of COD excluded from income is limited to the amount by which the taxpayer is insolvent. Insolvency is defined in IRC Sec. 108(d)(3) as the excess of liabilities over the FMV of assets, determined prior to discharge.

The exclusion of COD from income does come with a cost. As specified in IRC Sec. 108(b), the amount excluded from income must reduce tax attributes, thereby generally deferring (rather than permanently excluding) the inclusion of COD income.

Tax attributes are reduced in the following order:

• net operating losses;
• general business credits;
• minimum tax credits;
• capital loss carryovers;
• adjusted basis of property;
• passive activity losses and credit carryovers; and
• foreign tax credit carryover

IRC Sec. 108(b) notes tax attribute reductions are made after the determination of tax imposed for the year of discharge. Reductions of net operating losses and capital loss carryovers are made first for losses in the taxable year of the discharge and secondly in the carryovers to such taxable year in the order of the taxable years from which each carryover arose.  COD excluded in excess of the taxpayer’s tax attributes is disregarded with no resulting tax consequences. As an alternative to reducing tax attributes, a taxpayer may elect to reduce first the adjusted basis of their depreciable property to the extent of the excluded COD.

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.

In Summary

A foreclosure is treated the same as a sale of property. Capital gain or loss may be triggered upon such sale and, in certain instances, taxpayers may also realize income from forgiveness on certain mortgage debt.   Exclusions of income created in a foreclosure may be available to taxpayers but the specific facts should be first reviewed and all tax implications considered.  

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 circumstances. Please consult your real estate tax advisor for more information and clarity on these types of transactions.