If you are one of many real estate owners and developers negotiating with their lenders to modify existing debt on your properties, the recently enacted American Recovery and Reinvestment Act of 2009 (Stimulus Act) provides you with some beneficial tax relief.
With the tight credit markets, rising vacancies and stagnating or decreasing rents, owners are looking for ways to ease their debt burden. The move to negotiate with lenders for debt relief, including forgiveness, has become a more prevalent means of capital preservation and, in some cases, a survival tool for investors.
Modifying debt will often result in cancellation of debt (COD) income for tax purposes, particularly where the loan is reduced or the owner pays off the loan at a discount. Generally, COD is income taxed at ordinary rates to the borrower.
Assume an owner owes $100,000 on a mortgage and the lender agrees to reduce the principal to $60,000. Unless an exception applies, the owner will recognize $40,000 of ordinary income.
For partnerships, the COD income is recognized at the partner level. Insolvent or bankrupt debtors do not have to recognize COD income, but a solvent partner will still be subject to tax on his share of the partnership's COD.
Prior to passage of the 2009 Stimulus Act, the tax rules provided most real estate owners and investors with only one practical way to avoid immediately paying tax on COD. Under this exception, if a lender reduced the principal on a mortgage secured by a troubled property, the owner or investor could elect to reduce the tax basis of depreciable real property used in its trade or business.
But this exception is available only under limited conditions. An owner electing this exception thereafter will have smaller depreciation deductions on his property and will recognize more gain as ordinary income when he sells the affected property. In partnerships, each partner may choose whether to make the election.
Flexibility on existing debt
The 2009 Stimulus Act gives owners another alternative. The new provision adds substantial flexibility for taxpayers renegotiating existing debt because it allows them to defer COD resulting from 2009 and 2010 transactions until 2014. The owner must recognize 20% of the COD in 2014, and in each of the next four years.
The new alternative is simpler and has far fewer restrictions than the basis reduction rule, and, unless the debtor anticipates owning the real estate substantially beyond 2018, deferral provides greater tax benefits.
Applying this new rule to our prior example, if a lender in 2009 agrees to reduce the principal of a $100,000 mortgage to $60,000, instead of immediately paying tax on $40,000 of income, the owner can now defer the income until 2014 and recognize $8,000 in each year from 2014 until 2018.
Secured and unsecured debts are eligible. Property value isn't considered. The basis of an owner's property isn't reduced, and he continues to depreciate 100% of his original cost. The property must be used in the owner's “trade or business”. In the case of partnerships, the election must be made by the partnership and is binding on all of the partners.
Other key provisions
If the owner dies, sells substantially all of his property, or an owning entity liquidates prior to the end of the deferral period, any unrecognized COD will be accelerated into income.
If a partnership that owns only one property makes this election and sells the property in 2013, all of the deferred COD will be recognized. If, prior to the sale, the partnership acquired other property, it may be possible to avoid this result.
Deferred COD is allocated to the partners at the time that the debt is reduced. Any partner selling or redeeming his partnership interest prior to the end of the deferral period will trigger his portion of any unrecognized COD.
The lender often will allow the owner to defer some or all of the interest on the modified debt. The new deferral provision generally limits the ability of an owner to deduct accrued, but unpaid interest during the deferral period.
Literally thousands of commercial property owners are now asking their lenders for debt relief. The 2009 Stimulus Act alternative will allow them to restructure debt on their troubled properties without an immediate tax burden.
Harvey Berenson is a managing director in the New York office of The Schonbraun McCann Group, an FTI Company. He can be reached at [email protected].