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Tax Strategies for Real Estate Owners in Distressed Debt Scenarios

May 29, 2024

Current economic conditions such as, high inflation, rising interest rates, growing vacancy rates, and slower rental growth are causing an increase in distressed properties in the real estate market 

Real estate owners often finance property acquisitions with debt, which brings debt covenants, restrictions, and service requirements. When servicing debt becomes unviable or the fair market value of a property falls below the remaining debt balance, owners face tough choices.  

Debt Outcomes for Distressed Real Estate Owners  

Examples of debt outcomes for distressed real estate owners include:  

  • Principal Reduction: Lenders may agree to reduce the debt's principal balance. 
  • Debt Settlement: Borrowers might settle the debt at a discount. 
  • Debt Workout: Lenders may modify debt terms. 
  • Fire Sale: Owners may sell the asset quickly to satisfy the debt. 
  • Deed-in-Lieu: Owners may surrender the property without foreclosure. 
  • Foreclosure: If negotiations fail, lenders may foreclose and force a sale. 

In the first three scenarios, owners retain the property. In the worst-case scenario of foreclosure, owners not only lose the property, but may also potentially owe income tax on phantom income.  

Each scenario has different tax implications depending on the type and amount of debt, the fair market value of the property, and the owner’s tax basis of the property. Because of this, understanding the tax considerations related to debt for distressed real estate owners is crucial.  

Examples of Real Estate Debt Scenarios and Their Tax Implications Property is Retained Scenario 1: Lender reduces principal balance or agrees to settle debt at a discount.  

Tax Implications for Solvent Taxpayers 

Discharge of indebtedness income is typically considered ordinary income for solvent taxpayers. However, when this income is related to Qualified Real Property Business Indebtedness (QRPBI), some or all of it may be excluded from income, subject to two key limitations: 

  1. The exclusion cannot exceed the difference between the debt immediately before discharge and the net fair market value of the qualifying real property. Net fair market value is calculated by subtracting the outstanding principal amount of any QRPBI (other than the discharged indebtedness) secured by the property before and after the discharge from the fair market value of the qualifying real property. This rule prevents tax-free creation of equity in real estate. 
  2. The excluded amount cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge, after reduction for any depreciation claimed during the year and any basis adjustments under the insolvent tax attribute reduction rules. 

     For partnerships that own real property with QRPBI, the determination of QRPBI and fair market value limitations are applied at the partnership level. The election to apply the exclusion however is made at the partner level, and the exclusion from income also applies at the partner level. Partners must also consider the required basis reduction. Each partner’s interest in the partnership is treated as depreciable real property based on their proportionate stake in the depreciable real property held by the partnership. A corresponding reduction in the partnership’s basis in depreciable real property is with respect to that partner. 

    Tax Implications for Insolvent Taxpayers 

    The tax outcome for insolvent taxpayers depends on whether they are in bankruptcy or not.  

     For insolvent taxpayers not in bankruptcy, the discharged amount of debt is split into two buckets. 

    1. This portion can be excluded from income, but only up to the amount by which the taxpayer is insolvent (liabilities exceeding asset fair market value, immediately before discharge). Certain tax attributes of the taxpayer are reduced accordingly, deferring income recognition. 
    2. The remaining discharged debt is treated similarly to a discharge of debt for solvent taxpayers.  

      For taxpayers in a bankruptcy case, the entire discharged debt is excluded, but certain tax attributes of the taxpayer still need reduction (effectively deferring the recognition of the income).  

      Special Rule for Purchase Money Mortgages 

      A special rule exists for purchase money mortgages. If the property seller was also the lender during purchase and still holds the debt, debt reduction is treated as a purchase price adjustment for solvent taxpayers. However, this option doesn’t generally apply in insolvency or bankruptcy scenarios. 

      Unlike general exclusion rules (which apply at the partner level), the exclusion for purchase money mortgages operates at the partnership level. 

      Furthermore, for real property and debt held by a partnership, the partnership’s insolvency or bankruptcy status is disregarded. The IRS has stated that it will not challenge the purchase price adjustment at the partnership level if all other requirements are met (except insolvency or bankruptcy status). 

      Property is Retained Scenario 2: Lender and borrower agree to a debt workout (i.e., modifications to terms of debt).  

      When a debt modification occurs, it may be considered significant enough that the borrower is treated as if they issued a new debt instrument in exchange for the existing debt. The issue price of this new instrument represents is treated as money that is deemed to satisfy the existing debt. 

      If this issue price is less than the existing debt, it results in discharge of indebtedness income for the taxpayer. In other words, the borrower recognizes income for the forgiven portion of the debt. 

      A pure reduction of the principal balance of debt is treated as discharge of indebtedness income from the outset. This means that if a lender forgives part of the principal balance, the borrower must report it as taxable income. 

      Requirements for Deemed Exchange 

      Two key requirements need to be met for a deemed exchange to occur under debt modification rules:  

      1. A modification must occur, which includes any alteration (addition, deletion, or change) of legal rights or obligations related to the debt instrument. 
      2. The modification must be deemed significant. Specific examples include changes in yield, timing of payments, obligor or security, and the nature of the debt instrument.  

        Examples of Non-Significant Modifications 

        • A modification that adds, deletes, or alters customary accounting or financial covenants. 
        • A temporary forbearance from collection efforts or acceleration clauses by a lender for a period up to two years plus any additional period of good faith negotiations. 

        Property is Disposed of Scenario 1: Real estate owner sells real property or lender forecloses and forces a sale of real property. 

        In this scenario, normal gain or loss rules apply to sales of property and the amount realized includes cash and the FMV of any property received in the transaction: 

        • A gain occurs if the sale price exceeds the adjusted basis (the original cost plus any improvements less accumulated depreciation).  
        • A loss occurs if the adjusted basis is higher than the sale price.   

        If the sales proceeds aren’t enough to pay off all the debt, and the lender forgives the remaining balance then:  

        • If the debt is considered nonrecourse debt under the tax code, the forgiven debt is added to the amount realized for the gain or loss calculation. 
        • For recourse debt, the forgiven amount is treated as ordinary income from the discharge of indebtedness. However, there are exceptions related to insolvency and bankruptcy described above. 

        Property is Disposed of Scenario 2: Real estate owner transfers real property to lender in satisfaction of debt in a deed-in-lieu of foreclosure transaction.  

        In this scenario, the transaction is considered a property sale, where the amount realized matches the debt amount (which is satisfied through the transfer). The difference between the amount realized and the adjusted tax basis of the property determines whether there is a gain or loss.  

        If the debt is considered nonrecourse debt, the entire amount is treated as the amount realized. If the debt is considered recourse and exceeds the fair market value of the property, the transaction is split into two transactions 

        The fair market value of the property is considered the amount realized to determine the gain or loss on the deemed sale of the property. The excess of the recourse debt over the fair market value of the property is treated as discharge of indebtedness income which is ordinary income. However, this is subject to the insolvency and bankruptcy exclusions described above. 

        Other Tax Considerations for Deemed Sale Transactions 

        When real property changes hands due to voluntary or involuntary debt satisfaction and a deemed sale occurs, other collateral tax consequences need to be considered. In these scenarios, standard recapture and recharacterization rules apply, including ordinary income recapture related to accelerated depreciation and unrecaptured 1250 gain characterization.  

        Next Steps When Navigating Distressed Real Estate  

        Distressed real estate situations require careful planning and analysis. While the loss of a property can be economically devastating, the prospect of phantom taxable income exacerbates the hardship. Property owners finding themselves in distressed real estate situations should consider working through these key steps:  

        • Workout Options: Explore potential solutions with lenders. 
        • Debt Nature: Understand whether the debt is nonrecourse or recourse. 
        • Owner Solvency: Assess the financial health of property owners and partners. 
        • Exclusions: Analyze potential exclusions to mitigate tax impact. 

        Given the complexities, consulting a tax advisor is highly recommended. If you have questions about a distressed real estate situation, connect with our team below to talk through your specific scenario.

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        Michael Torhan

        Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.

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