Tax strategies for commercial real estate debt workouts

‘Qualified debt in the real estate business’

While the insolvency exception is passed on to the shareholder in many cases, taxpayers, with the exception of C corporations, have the option of excluding cash on delivery income from the “qualified debt of the real estate business” at company level. This exception only applies to debts that have arisen in connection with a commercial or business property and are secured by this. In the case of partnerships, disregarded entities, and grantor trusts, the income exclusion and election are reported at the partner level. Conversely, the determination of whether it is a qualified real estate business debt is made at the partnership level.

The following criteria must be met for debts to qualify as qualifying real estate business debts:

• The property must be held by the partnership in connection with a business operated by the partnership.
A rental agreement under a triple net lease cannot be considered a trade or business.

• The debt was taken on or accepted in order to purchase, build, convert or significantly improve the property.

• The partner must make a timely choice in the income tax return by submitting Form 982.

The amount of cash on delivery income from qualified real estate business debts is determined at the partnership level. It is limited to the excess of the outstanding nominal amount of the debt immediately before repayment over the market value of the property, less the outstanding nominal amount of another qualifying real estate business debt that is secured by this property. As soon as the amount is determined, the choice is made by submitting Form 982 with the partner’s income tax return, combined with a reduction in the basis of the partner’s share in the partnership by the amount of cash on delivery income and the basis of the property assets is excluded on the tax return of the following year.

Foreclosures

In the case of foreclosure, whether voluntary (replacement deed) or involuntary, the lender acquires ownership of the secured property in order to settle the outstanding debt. The transaction is generally viewed as a real estate sale, but the tax treatment also depends on whether the debt is regressive or nonregressive.

If there is a foreclosure on a claim without recourse, the outstanding principal debt balance will be included in the proceeds from the sale of the property. Profit or loss is either marked as profit under Section 1231 on business property, subject to depreciation, or as capital gain on investment property. The profit can also be subject to the depreciation regulations according to § 1250. The fair value of the property does not affect the amount realized for income tax purposes.

The same rules generally apply when dealing with recourse debt, except when the recourse debt exceeds the FMV of the property being returned. In this case, the transaction is considered to be two independent transactions where the taxpayer may need to recognize ordinary income and capital gains or losses. First, the taxpayer will recognize cash on delivery income to the extent that the waived debt exceeds the FMV of the property at the time of foreclosure. Second, a sale or exchange is assumed to have occurred and the gain or loss is determined by calculating the difference between the realized amount (the debt forgiven minus the portion treated as cash on delivery income) and the property’s adjusted tax base. In situations where the property’s FMV is less than its adjusted tax base, a taxpayer may experience a capital loss (normal loss if the underlying security was a property under section 1231) and cash on delivery receipts on the same transaction. This would result in a net effect of the same total gain or loss that would have occurred if the property had been secured by an open debt.

There are several strategies for restructuring, modifying, or eliminating liabilities that can reduce the adverse federal and state income tax consequences of cash on delivery, depending on individual facts and circumstances.

We’re here to work with you to find the best approach for you and your business. Please contact your Citrin Cooperman specialist today to find out more.

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