Many clients are facing difficult decisions as loans come due on various properties. There are vastly different tax consequences of transactions that may appear economically similar.
If an owner hands the keys back or allows a lender to foreclose on a non recourse note, he is treated as selling the property for the amount of the debt. This is not cancellation of indebtedness (COD) income, it is gain on sale. For example, assume a tax basis in assets of $20 million, a current fair market value of $24 million and a loan balance of $30 million. If the loan is non recourse, the owner has a $10 million gain on foreclosure and no COD. If a loan is recourse and the lender takes back the property, the gain is the difference between fair market value and basis, or $4 million in our example. To the extent the $6 million recourse balance is compromised, there will be COD. Assuming that COD is preferable to gain income (discussed below), the tax consequences of a non recourse loan can be more severe than those of a recourse loan.
For a non recourse borrower to recognize COD, either the lender has to reduce the size of the debt or accept an amount less than face in satisfaction of the debt. In some instances, Lenders agree to a partial write down to gain borrower cooperation. In our example, the owner may ask the lender to reduce the size of the loan to $24 million, and may pay something for this, to create $6 million of COD and decrease ultimate taxation. But, for COD to be recognized by the IRS, there has to be a write down of the loan with the borrower having the chance to refinance the resized loan. If the resizing and the conveyance to the lender are linked or are too close in time, the IRS will not recognize any COD and will treat all gain as sale proceeds.
"While it may seem counter intuitive, COD often is preferable to gain income. Gain income reduces NOL’s or incurs immediate taxation for individual owners. COD income can be delayed for all business taxpayers under special relief recently enacted. In addition, individual owners (not C corporations) can elect to apply COD to reduce the basis of other depreciable real estate assets. The basis exception only applies to debt to the extent the proceeds were invested in the property. To the extent the debt was used to make cash distributions to the owners, basis reduction is not available. Basis reduction is also recaptured at ordinary income rates upon a sale. However, this recapture “burns off” as the owner foregoes depreciation deductions on the reduced basis. Going back to our example, assume that $4 million of the $30 million financed distributions to partners. If the debt is compromised for $24, there will be $6 million of COD. However, only $2 million of that debt will be eligible for the real estate basis reduction election.
The election to delay gain until 2014 and then to spread out recognition over a 5 year period is open to C corporations and all business taxpayers. If a partnership of individuals rents a property, it is engaged in business and is eligible for the deferral. If the partnership holds raw land for development, the answer could be different. The delay election is made by the partnership or other entity, not by its owners. However, the election takes away the ability of individual owners of real estate partnerships to reduce basis. There are a number of procedural and substantive issues that have to be resolved concerning this election that the IRS needs to address. The potential conflict between a C corporation partner (which includes REITs) and individual partners over the benefit of a deferral election is just one of these issues.
To contrast the possibilities, and perhaps enable an owner to pick the lesser evil, foreclosure produces gain, some of which may be taxed at capital gains rates, although there undoubtedly will be depreciation recapture rate taxation. A basis reduction election spreads gain out over the depreciable life of the asset at the cost of the loss of ordinary income deductions. The deferral election produces ordinary income in the future, which contrasts with capital gain type taxation today.
In our experience, most owners will elect to defer taxation, even if the ultimate amount increases, at least in theory. If the owner intends to hold the realty for the rest of his or her lifetime and allow his or her estate to obtain a basis step at death, then deferral is elimination. Even if the hold time frame is not that long, in harsh economic times most clients prefer deferral to going out of pocket for immediate taxes.
Please call or contact Larry Arem (215.569.4142 or firstname.lastname@example.org with any questions or to discuss a particular matter. Each situation is very fact specific and the deferral election is under active study by the IRS to resolve multiple ambiguities.
CIRCULAR 230 NOTICE. Any advice expressed above as to tax matters was neither written nor intended by the sender or Klehr, Harrison, Harvey, Branzburg & Ellers LLP to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. If this document is delivered to any person or party other than to our client to whom the advice is directed, the recipient may not and should not rely upon any advice expressed above for any purpose and should seek advice based on the recipient’s particular circumstances from an independent tax advisor.