The COVID-19 pandemic has had a dramatic impact on commercial real estate values, and in some cases resulted in property no longer being able to support the debt with which it is encumbered.
The decrease in value of commercial property has forced many owners to restructure their debt. However, the resulting forgiveness of a portion of the debt does not automatically result in federal taxable income. Favorable rules, which were put into place for taxable years after 1992, could allow the cancellation of debt income to be deferred for federal income tax purposes even if the taxpayer is not in bankruptcy or insolvent—as is normally the case.
Taxable income is closely linked to when a taxpayer receives economic benefit. So it makes sense that if you previously had a $100,000 bank loan and the bank decreases the principal balance to $80,000, then your $20,000 economic benefit should be included in taxable income. The decrease in debt principal is often referred to as a discharge of indebtedness or cancellation of indebtedness. Under certain circumstances, the Internal Revenue Code allows for income related to the cancellation of indebtedness to be excluded from a taxpayer’s income in instances of a title 11 (bankruptcy) case or where the taxpayer is insolvent. Insolvency is defined as the excess of the liabilities over the fair market value of assets. The ability to claim insolvency at the entity level is limited to C and S corporations. For partnerships, the most common entity type for real estate holdings, insolvency must be measured at the individual partner level. This can pose an issue because, often times, the individual partners are solvent (i.e., not insolvent).
However, being insolvent or in bankruptcy is not the only way that taxpayers involved in real estate can exclude cancellation of debt income. Provided the taxpayer is not a C corporation, cancellation of debt income can be excluded if the debt discharged is consideredqualified real property business indebtedness (QRPBI). QRPBI is debt that is incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such property. For property acquired on or after January 1, 1993, QRPBI includes debt used to acquire, construct, reconstruct, or substantially improve real property. Whether a taxpayer is engaged in a trade or business is not always an easy question to answer and rental arrangements utilizing a triple net lease need to be carefully reviewed to ensure they qualify as a trade or business.
As always, there is a catch. The IRS is not going to allow an exclusion from taxable income out of the kindness of its heart. Instead, the Internal Revenue Code essentially allows a swap; in exchange for an exclusion of cancellation of debt income relating to QRPBI that is not due to insolvency or bankruptcy, the rules allow a taxpayer to elect to reduce the tax basis of the taxpayer’s depreciable real property under section 108(b)(5). The amount of the exclusion and basis reduction is the excess of the outstanding principal amount of the debt less the FMV of the business real property immediately before discharge. The FMV of the property is reduced by any other qualified real property debt secured by the property.
Let’s look at an example. Assume that Julia acquires a building in 2018 that she uses in a trade or business. In 2021, the building is subject to a first mortgage of $110,000 and a second mortgage of $90,000. The FMV of the building in 2021 is $150,000. In 2021, Julia’s bank agrees to reduce the second mortgage debt from $90,000 to $30,000, resulting in cancellation of debt income of $60,000. The outstanding principal debt immediately before discharge was $90,000, which exceeds the FMV of the property less the first mortgage ($150,000-$110,000) by $50,000. Therefore, Julia would be able to exclude $50,000 of income and would be required to include only $10,000 of cancellation of debt income.
For Julia to ensure the $50,000 is not included in taxable income, her aggregate adjusted tax bases of depreciable real property must be at least $50,000. The basis reduction, provided by section 1017, will apply beginning on the first day of the taxable year following the year of discharge (or immediately before the disposition if the property is disposed of before the end of the taxable year). In our example, Julia would have to include the $10,000 of cancellation of debt income in her 2021 tax return and adjust her basis in her real property by $50,000 as of January 1, 2022.
If the property is not held directly by an individual, but instead is held by a partnership, then the determination of whether debt is QRPBI (and the application of the FMV limitation) is made at the partnership level. However, the decision as to the basis reduction is made and elected at the partner level. This allows each partner to weigh their unique individual income tax circumstances and come to their own conclusion.
Individual taxpayers, including partners in a partnership, must file Form 982 to defer the treatment of cancellation of debt income and elect to reduce their basis in depreciable property. Such an election must be made on a timely filed return, including extension, and can only be revoked with the consent of the IRS.
For real estate investors who restructured certain real property debts due to the COVID-19 pandemic, the ability to defer the cancellation of debt income could be a great tax planning opportunity, allowing them to avoid immediate taxable income and IRS cash payments.