As markets conditions continue to squeeze both landlords and their tenants, renegotiating loan terms can be an effective strategy for property owners to reduce overhead. But beware – the financial implications aren’t as simple as they sound. Many property owners fail to realize that renegotiated or discharged debt doesn’t just cease to exist. Further, other owners are not aware that they’ll probably need to realize the savings as income. And yes, if you cancel or decrease your debt, you will be liable for taxes on it.

There are three ways property can be surrendered in discharge of debt. Foreclosure is a legally defined procedure for a secured lender to acquire secured property. This is an expensive, time-consuming process for a lender. A deed in lieu is a voluntary transfer of property to the lender in lieu of foreclosure proceedings. A short sale is the sale of property to a third party for an amount less than the debt owed to the lender.

Tax Implications

Borrowers may realize two types of income or loss when relinquishing properties. The first is gain or loss on the sale of the property. The second is cancellation of debt income also known as “discharge of indebtedness income.” In either instance borrowers 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 by the borrower or otherwise acquired by the lender, and Form 1099-C, “Cancellation of Debt,” issued when debt is canceled in connection with the surrender of property in discharge of debt.

The nature of the debt determines the tax implications. Is the canceled debt recourse or nonrecourse? With recourse debt, the lender has recourse against the borrower for the debt. With nonrecourse debt, the lender may only take property that secures the loan as satisfaction of that loan. Pure nonrecourse loans are very rare today. Occasionally a loan can have both a recourse provision for a limited amount and a nonrecourse provision that permits the lender to retain possession of the secured property.

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 nonrecourse 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 nonrecourse 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 nonrecourse 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 debtor 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 renegotiation of commercial real estate debt. Typically the overall effect is positive, but it’s important to consult your tax advisers for guidance.

Dennis J. Fitzpatrick, JD, is a tax principal with Kaufman Rossin, a Florida-based certified public accounting firm. Contact him at dfitzpatrick@kaufmanrossin.com.