Many real estate entities operate as partnerships and limited liability companies taxed as partnerships, and the tax consequences flow through to the partner level. So, what exactly are the consequences from a tax perspective?
Liabilities on a partnership tax return are classified as either recourse, non-recourse, or qualified non-recourse. This characterization comes into play because the type of loan affects the partners’ outside basis calculation, and partners can only make use of losses generated by a partnership to the extent of their outside basis, which includes the tax basis of the partner’s share of certain partnership liabilities.
A recourse liability is one in which the partnership and its general partners would be obligated to pay personally (or contribute the amount to the partnership to pay the liability), meaning the partner would bear the economic risk of loss. With respect to non-recourse liabilities, the partnership and none of its partners have a personal risk of loss. Qualified non-recourse liabilities are an exception to non-recourse liabilities because the debt is borrowed in connection with real property and the lender or guarantor is a government agency or “qualified” lender. Qualified lenders include banks and loan associations. Recourse and qualified non-recourse liabilities are included in partners’ outside basis calculations, but not recourse liabilities.
However, for the purposes of determining the tax implications of a foreclosure on real estate held in a partnership, the liabilities are defined only as recourse or non-recourse. Due to the different definitions, it is important to review the loan agreements when calculating tax consequences.
Reviewing the loan agreement is critical because some provisions in commercial mortgage transactions can result in the conversion of a non-recourse loan into a recourse loan. For example, this can occur where the borrower engages in deceitful business activities or fails to maintain insurance or to pay property taxes.
Lenders on a non-recourse loan have recourse only to the collateral in the event of a default. They have no ability to be made whole through a deficiency judgment against the borrower, as they would in the case of a recourse loan. With a defaulted recourse loan, the lender can take ownership of and sell the underlying property, and also attempt to collect any remaining amounts due through a separate lawsuit to obtain a deficiency judgment against the borrower and any guarantors of the loan. Depending on the state, the deficiency judgement will include the remaining unpaid principal, accrued interest and any attorney fees after the sale of the property.
The tax implications of a loan default will be determined by the type of loan as well as the remedy chosen by the lender. If a lender chooses not to foreclose on the underlying property, for whatever reason (e.g., environmental concerns), then the lender is limited to working out the loan through a modification or selling it. In this case, the tax consequences are deferred until there is a disposition of the loan.
The subsequent illustrations will use the following fact pattern for an LLC taxed as a partnership. Let’s say the business principal loan balance is currently $30 million. The tax basis in the property is $8 million and the fair market value is $24 million.
From a tax standpoint, a non-recourse loan foreclosure is treated as if the property was sold for the remaining balance of the loan. Therefore, a $22 million capital gain would be recognized resulting from the difference between the loan balance of $30 million and the remaining tax basis of $8 million. This capital gain,subject to recapture rules, would pass through to each partner on their K-1s. Any partners who have outside basis could then apply their portion to their capital gain.
In the event of foreclosure of a recourse debt, however, the partnership would be “at risk,” and there are two pieces that factor into the tax FMV of the property. In addition to a capital gain of $16 million (computed as the FMV of $24 million less the tax basis of $8 million), the second piece depends on whether the deficiency, if any, is collected or forgiven. If the partnership pays the remaining balance of the loan, then that would finalize the debt settlement. However, if that is not the case, the next step in computing the tax treatment would include the lender’s cancellation of indebtedness (COD). In this case, the COD income for the partnership would be the difference between the remaining loan balance and the FMV of the property. In this example, the COD income would be the $30 million less the $24 million for an inclusion in ordinary income of $6 million.
Another twist to this relates to certain exclusions and provisions nestled in the tax code. In particular, there are exclusions available relating to COD income for to the individual partners themselves. If any partner was insolvent (his/her assets are less than his/her liabilities) or bankrupt, the COD income would not be includible in income. Another notable exception is that if the payment of the debt would have been deductible, that COD is not included in the income. If there was $1 million of unpaid accrued interest, the partnership would have been able to deduct that as interest expense. Since it was not paid or deducted as an expense, and the debt was canceled, the accrued interest is not factored into the COD income amount.
When making a business decision to default on a mortgage, digging through the details and clarifying the type of loan and the related implications becomes critical when determining how the resulting tax consequences will unravel.