The Tax Nuances of Debt Modification

The real estate industry is currently facing unprecedented challenges as the period of reduced interest rates and low inflation has come to an end and economic uncertainty continues to prevail. Most recently, the failures of Silicon Valley Bank and Signature Bank have put the real estate industry on high alert as owners and lenders prepare for the aftermath.

In a distressed real estate market, owners and lenders may consider debt restructuring and renegotiating their loan terms to manage their cashflow. However, taxpayers are often surprised to learn that modifying the terms of their debt could have substantial tax ramifications. It is important for owners and lenders to consider all their tax options before developing a strategy to minimize their compounding debt. In this article, we will review various tax implications for debt modifications and foreclosures.

Debt modifications

Debt restructuring can take many forms. For example, the lender can agree to modify the terms of the indebtedness by reducing the principal amount and/or deferring the unpaid interest, and thereby allowing the borrower to keep the property subject to the restructured debt.

For income tax purposes, one should consider whether a modification of an existing debt constitutes a “significant modification.” If a “significant modification” occurs, the existing debt is deemed to be exchanged for a new debt instrument and the old debt is treated as having been retired for an amount equal to the issue price of the new debt. As a result of a “significant modification” to a debt instrument, a taxpayer will generally recognize the cancellation of indebtedness (COD) income to the extent that the adjusted issue price of the old debt exceeds the issue price of the new debt.

For borrowers that are insolvent, the COD income could be partially or entirely excluded from income.

If the income from the discharge of indebtedness cannot be excluded because the taxpayer is solvent, then the income may be excluded if the debt constitutes qualified real property business debt.

Foreclosures

If the borrower is unable to achieve a satisfactory work-out of its debt obligation with the lender, the borrower can simply surrender the property to the lender. The tax consequences in the event of a foreclosure or surrendering the collateral to the creditor will depend on the nature of the debt (nonrecourse or recourse).

Nonrecourse debt: If a borrower surrenders property subject to a nonrecourse debt to the creditor in satisfaction of the debt, the borrower is treated as having transferred the property in exchange for an amount realized equal to the outstanding balance of the debt. The borrower will recognize gain measured by the difference between the amount of the loan forgiven and the borrower’s tax basis in the real property. The borrower doesn’t recognize COD income.

Recourse debt: In the case of a foreclosure involving recourse debt, the analysis is more complicated and the consequences to the borrower might be unpleasant unless they have planned properly.

To the extent that the amount of the debt cancelled exceeds the value of the property transferred, the debtor will have COD income that, if not otherwise excludable, will be taxable at ordinary income rates. The debtor will also have a phantom gain to the extent that the FMV of the building secured by the recourse debt exceeds the adjusted basis of that property.

Debt restructuring can produce phantom taxable gains even though no cash proceeds are received. Real estate owners must be aware of the tax ramifications of debt modification and be prepared to set aside cash for taxes owed arising from these transactions. For this reason, it is important for businesses to partner with their tax advisor early on to develop a tax strategy to minimize tax ramifications.

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Aleksander Dziedzic is a partner with Anchin’s Real Estate Group. For more information, please contact Dziedzic at Aleksander.Dziedzic@anchin.com