Being a commercial property owner right now brings many surprises, but there's one big surprise you want to avoid. If you have renegotiated your commercial property loan in order to reduce the payment terms, you may need to claim the total amount you saved as income on your upcoming tax return. It’s called cancellation of debt income, and you may be liable to pay the taxes incurred on this income.
Renegotiating remains an effective strategy to reduce overhead in the short term and improve operations. This can help maintain control of your property and provide some fiscal breathing room for an extended period of time. However, it’s important to include the tax impact when considering this option.
Many properties are also being surrendered to lenders to obtain relief from debt. Many of these owners fail to realize, however, that not all of the debt may be extinguished if they are personally liable for that debt. Every case will have its own issues, so we’ll begin with a few generalities. There are three ways property can be surrendered in discharge of debt:
Foreclosure: a legally defined procedure for a secured lender to acquire secured property. This can be expensive and time consuming.
Deed-in-lieu: a voluntary transfer of property to the lender in lieu of foreclosure proceedings.
Short-sale: the sale of property to a third party for an amount less than the debt owed to the lender.
Two types of income or loss may exist when a borrower abandons their property in any of the three ways mentioned above: gain or loss on the sale of the property and cancellation of debt income, also known as discharge of indebtedness income. In either instance, the borrower may need to recognize this taxable income. The specific tax implications depend on whether the type of debt is recourse or nonrecourse. Recourse debt means that the lender has recourse against the borrower for the debt. Nonrecourse debt means that the lender may only take property that secures the debt to satisfy the loan. This type of debt is rare. In some cases, a loan can have a blend of these elements.
The taxable gain or loss from a deemed sale on the surrender of property in the discharge of a recourse debt is calculated as the difference between the outstanding debt and the basis of the property. Subsequently, cancellation of debt income is also recognized on the surrender of property in discharge of a recourse debt. The amount of this COD income is the difference between the fair market value of the property and the amount of debt owed. Discharge of a nonrecourse debt is calculated as the difference between the amount of outstanding debt and the borrower's basis in that property. Since the terms of the loan eliminate the rights of the lender to pursue the owner personally following default, the discharge of a nonrecourse debt does not result in taxable cancellation of debt income.
There are three main exclusions under which commercial property owners may exclude the realization of cancellation of debt income following the surrender of property in discharge of a recourse debt. The first exclusion is for debts that have been discharged in a Title 11 bankruptcy proceeding. The second exclusion is available for debtors who are insolvent at the time the debt is discharged. The amount of COD income that may be excluded is equal to the amount that a debtor is insolvent. The third exclusion is for the discharge of qualified real property business indebtedness. Certain tax attributes of the debtor will need to be decreased by the total cancellation of debt income that is excluded. The tax attributes that must be reduced include net operating losses, capital or passive activity losses, tax credits and depreciable basis in other properties.
In most cases, renegotiating commercial real estate debt with your lender will be very beneficial, but determining the tax implications before finalizing any deal is essential. Consult your tax advisors for guidance if you own commercial property and are considering such a negotiation this year or have already done so in 2009.
‘ Dennis J. Fitzpatrick, J.D., is a tax principal with Kaufman, Rossin & Co.