When business economic conditions change substantially, commercial property net rental income and cash flow may deteriorate and become insufficient to meet the expenses of owning, operating and maintaining the property. This often results in a true decline in the economic value of the property.
If debt restructuring is not feasible, the reduced value may leave the owner little or no economic incentive to maintain ownership of the property. The owner may prefer to stop paying the mortgage all together or to negotiate a means of escaping or otherwise minimizing financial obligations under the mortgage and other loan documents. Obtaining the least detrimental income tax treatment from the termination of the ownership of the property should be carefully considered.
Federal income tax liability without cash to pay for it may result from foreclosure or deed in lieu transactions—making timely planning for tax deferral, reduction or possible forgiveness important. One income tax that may result is computed at high ordinary tax rates—cancellation of indebtedness income (“COD” income). In 2013 and later, COD income may for some taxpayers be subjected to the new 3.8% income surtax, to the extent threshold levels of applicability for the surtax are exceeded.
COD income may result if some or all of mortgage and/or other debt is eliminated. Generally, the debt is treated as having been paid in the amount of the fair market value of the property transferred or forfeited to the lender in a foreclosure or deed in lieu transfer. The excess of any recourse debt over the amount treated as paid is taxable COD income. If the value of the property is greatly diminished, the amount of COD income may be substantial.
In addition, a foreclosure or deed in lieu transaction involves a transfer of property to partially or fully satisfy debt that is taxed like a common sale or exchange—the fair market value of the property is treated as an amount received by the borrower and may result in capital gain, if in excess of the income tax basis of the property and the property was a capital asset to the owner. Although capital gain is taxed at lower tax rates than COD income, it still may produce a current income tax liability from a transaction that does not yield cash to pay the tax.
Planning for foreclosure or deed in lieu transactions is important for more than cash flow reasons. Capital gain or loss should be projected to analyze if it may be netted against other capital gains or losses to reduce or eliminate the tax impact. Planning prior to tax year end may well achieve optimal results. Recent cases decided adversely to borrowers and the legislative response have captured nationwide attention and increased the perception of risks of nonrecourse debt conversion and possible COD income. These risks (and others) should be analyzed. Qualifying to exclude COD income from a taxpayer’s taxable income is the key to protecting against this risk, and to achieve deferral or possible escape from COD income.
The good news is planning may reduce tax exposure. COD income from a deed in lieu transfer or foreclosure may be excluded under several separate statutory exclusions. Generally, these exclusions permit the deferral of income and resultant income tax, and in some instances may result in a forgiveness of tax.
For example, a bankrupt mortgage debtor who is discharged may exclude COD income. An insolvent mortgage debtor may also exclude COD income to the extent of the insolvency. However, exclusion of COD income from property owned by a limited liability company (“LLC”) is only available for LLC members, not for the LLC. If the LLC’s members are not all bankrupt or insolvent, the most favorable exclusion available may be the federal income tax exclusion for COD income from “qualified real property business indebtedness.”
The qualified real property business indebtedness exclusion (“QRPBIE”) is available for certain solvent owners (or, for example, LLC members) to permit the exclusion of COD income. A major advantage of this exclusion provision is that not all LLC members must be bankrupt or insolvent for the exclusion to apply.
The QRPBIE applies to property used in a trade or business and to certain mortgage debt secured by property used in a trade or business. Generally, the debt must have been incurred or assumed by the owner to acquire, construct, reconstruct or substantially improve the property. The owner must have sufficient tax basis in the depreciable property (and/or other real properties) because one of the QRPBIE’s limitations is that the amount of COD income excluded cannot exceed the owner’s depreciable basis in the subject property and other real properties.
The income tax basis adjustments that must be made are different for the QRPBIE than for the bankruptcy and insolvency exclusions because the QRPBIE exclusion requires that the owner reduce the basis of the property that secures the mortgage debt by the amount of the COD income, before the calculation of gain or loss on the deed in lieu transfer or foreclosure.
Upon determination of the COD income resulting for a taxpayer from a deed in lieu transfer or foreclosure of property, comparison of the tax resulting from a calculation assuming an election to exclude COD income and a calculation not excluding COD income must be made to determine which is better for that taxpayer. Of course, the taxpayer’s other tax circumstances will influence the conclusion.
Assume that a taxpayer LLC member prefers to exclude any COD income incurred on a deed in lieu transfer or foreclosure of the property. If the mortgage debt involved is nonrecourse, no COD income will be recognized, and planning for COD income exclusion may be unnecessary (unless debt conversion occurs). However, if the mortgage debt is recourse, COD income may be recognized by the owner if the debt has been discharged, and the COD income would be allocable to the LLC member. The LLC member may choose to exclude any COD income, by seeking to qualify for the QRPBIE.
Cooperation between a taxpayer’s advisors and early communication in planning to claim the COD income exclusion under the QRPBIE by the LLC member is important because the QRPBIE regulations require an election to reduce basis, and impose other prerequisites that must be complied with before the due date (including extensions) for filing the LLC member’s federal income tax return for the taxable year in which the COD income would be excluded under the QRPBIE. In the case of a deed in lieu transfer or a foreclosure, a preferable time for planning and communicating with all involved concerning the QRPBIE election is substantially sooner than the tax return filing deadline. Planning before the end of the taxable year may be most beneficial.
For further information regarding these matters, please contact Mr. Acker at 248.740.5665 or via email. This article was digested by the author from an article published in the State of Michigan Real Property professional journal, the Real Property Review, Fall 2011.