Many of our clients have looked to renegotiate the debt on their property. The down side is that cancellation or a debt reduction may create taxable income.
This is a complicated area of law, so extreme care should be taken when negotiating a debt reduction. We have put together a brief overview of the tax implications of these types of transactions.
Taxpayers may realize two types of income or loss when restructuring debt. The first is a gain or loss on the sale of the property. The second is cancellation of debt (COD) income also known as “discharge of indebtedness income.”
You will receive either or both of the following tax forms: Form 1099-A, “Acquisition or Abandonment of Secured Property,” issued by a lender when it becomes aware that a property has been abandoned or otherwise acquired by the lender. This is common when we relinquish the property through foreclosure, deed in-lieu or a short sale. Form 1099-C, “Cancellation of Debt,” issued when debt is canceled in connection with the discharge of debt.
As a general rule, you will not have to recognize income on transactions related to your primary residence.
To further complicate the matter, the nature of the debt determines the tax implications. Is the canceled debt recourse or non-recourse?
Recourse debt means that the lender can hold the borrower liable for any unpaid balance. Non-recourse debt means that the lender may only take property that secures the loan as satisfaction of that loan.
For recourse debt, the (taxable) gain or loss on the surrender of property is calculated as the difference between the amount of debt owed on the property and the fair market value of that property. In addition, cancellation of debt income realized on the surrender of property in discharge of a recourse debt is calculated as the difference between the fair market value of the property minus the amount of debt owed. This income is taxable.
For discharge of a non-recourse debt, the gain or loss on the surrender of property is calculated as the difference between the amount of debt owed on the property and the borrower’s basis in that property. This also is taxable. However, the forgiveness of a non-recourse debt does not result in taxable cancellation of debt income, since the terms of the loan do not give the lender any rights to pursue the owner personally in case of default.
It appears that borrowers with non-recourse loans are much better off. But that isn’t always the case. There are three exceptions when commercial property owners may exclude the realization of cancellation of debt income following the surrender of property in discharge of a recourse debt.
- If the debtor’s debts have been discharged in a Title 11 bankruptcy proceeding, it may be excluded.
- If the debtor is insolvent at the time the debt is discharged, the amount of COD income equal to the amount that a debtor is insolvent may be excluded. The amount of insolvency is measured as the difference between the value of all of the debtor’s assets and all of the debtor’s liabilities.
- If the discharge is of “qualified real property business indebtedness,” certain tax attributes of the taxpayer will need to be reduced by the amount of COD income that is excluded. The tax attributes that must be reduced include operating or capital or passive activity losses, tax credits, and depreciable basis in other properties.
To avoid unpleasant surprises, make sure to assess all of the tax implications before completing the transaction. Typically the overall effect is positive, but it’s important to consult with us about the specific tax consequences of your transaction.