With tenants closing and businesses moving to remote environments, the real estate industry is facing some intimidating hardships. Most of which can cause property owners to skip debt payments and work with their lenders to restructure debt. It’s important to understand the tax consequences of debt forgiveness or loan modifications and how to avoid a surprise tax liability.
Beware cancellation of debt income
Borrowers and their lenders might be considering debt restructuring to provide some relief to distressed businesses, but even loan modifications or lender discounts can trigger an unforeseen taxable exchange. Significant loan modifications are deemed as the borrower receiving an exchange of new debt for old debt and can trigger cancellation of debt (COD) income if the borrower’s liability is deemed to have been reduced. Changes in timing of payments, yield on the instrument, or change in obligor or adding a co-obligor could be considered significant modifications. Therefore, a detailed analysis of the borrower’s facts and circumstances is needed to determine if an income event has occurred.
I’ve got COD income. Now what?
There are options to defer the tax associated with COD income. Analyze the provisions under IRC Section 108 to determine if there are exclusions the taxpayer can rely on to defer recognizing the discharged debt income.
A borrower can exclude COD income to the extent of their insolvency. Pursuant to IRC Sec. 108, a debtor is insolvent to the extent its liabilities exceed the fair market value of its assets, determined immediately before the cancellation. For purposes of this analysis, the debt being extinguished is included in the insolvency computation. It’s important to note, insolvency is determined at the partner level, not the partnership level. When a partnership is insolvent, but the partner is solvent, partners are unable to utilize this exclusion.
Discharged income from QRPBI isn’t tax-exempt but is tax-deferred; therefore, the taxpayer needs to reduce the basis in their property.
If a taxpayer excludes the COD income under insolvency, the taxpayer must reduce other specific tax attributes by the amount of debt income excluded pursuant to IRC Sec. 108(a), such as net operating loss and net operating loss carryovers, general business credit carryovers, and basis in depreciable and nondepreciable property.
Qualified real property business indebtedness (QRPBI)
Real estate businesses who may be experiencing financial strain and looking to restructure loans but who don’t meet the insolvency exclusion criteria can get COD relief from the QRPBI exclusion. This exclusion defers the recognition of COD income by reducing the basis in the taxpayer’s depreciable property by the amount of income excluded.
QRPBI is defined as debt incurred in connection with real property: used in a trade or business secured by the real property, incurred or assumed before 1993, or is qualified acquisition indebtedness (QAI), and the taxpayer makes the QRPBI election. QAI is defined as debt incurred to acquire, construct, reconstruct, or substantially improve real property or debt resulting from the refinancing of QAI. There are specific rules that apply — carefully analyze both types of debt and the amount of COD income that can be excluded. A QRPBI exclusion is a good option for any taxpayers who couldn’t exclude all the COD income under the insolvency exclusion since the QRPBI exclusion can apply to the extent the taxpayer is rendered solvent.
Discharged income from QRPBI isn’t tax-exempt but is tax-deferred; therefore, the taxpayer needs to reduce the basis in their property. They’ll do this by first reducing the basis in the depreciable property secured by the discharged debt and then any amount not absorbed by that property is applied ratably against other depreciable property held by the taxpayer. Thus, it’s possible for a taxpayer to have QRPBI on nondepreciable property, such as land, that can reduce the basis of depreciable real estate. Any reduction in basis because of the QRPBI exclusion is treated as depreciation and is subject to taxation when the property is sold.
The QRPBI exclusion provision is applied at the partner level rather than the partnership level. When a partnership debt is discharged, it’s treated as an item of income and is allocated separately to each partner. The election to exclude the income under QRPBI exclusion is made separately by each partner of the partnership on their individual tax return.
As businesses navigate through these uncertain times, taxpayers should work closely with experts to determine if any transactions generate COD income and how to apply the provisions pursuant to IRC Sec. 108 to manage tax obligations and avoid surprises. Feel free to reach out with any questions about COD income or how to utilize QRPBI. We’re happy to help.