If you own commercial property and have renegotiated the terms of your loan in order to get relief you will probably need to realize the savings as income on your taxes this upcoming year.

And yes you will be liable for taxes on it.

Commercial property owners are lining up to try and decrease their interest rates – and in many instances even surrender the property – to their lenders in an effort to gain relief. As owners and their tenants continue to feel the squeeze of market conditions this can be an effective strategy to reduce overhead. What many of these owners fail to realize is that this renegotiated or discharged debt doesn’t just cease to exist. This article provides a general overview of current tax law in these matters.

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 and time-consuming procedure for a lender to acquire secured property.

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.

There are two types of income or loss that a borrower may realize when relinquishing a property in any of the three ways mentioned above: gain or loss on the sale of the property and cancellation of debt income (COD) also known as “discharge of indebtedness income” (DOI).

In either instance the borrower will receive either or both of the following tax forms: Form 1099-A “Acquisition or Abandonment of Secured Property” issued by a lender when they become 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 tax implications are determined based on the nature of the debt: recourse or non-recourse. With recourse debt the lender has recourse against the borrower for the debt. With non-recourse debt the lender may only take property that secures the loan as satisfaction of that loan. Pure non-recourse loans are very rare today. Occasionally a loan can have both a recourse provision for a limited amount and a non-recourse provision that permits the lender to retain possession of the secured property.

Here’s how it works:

The taxable gain or loss on the surrender of property in discharge of a recourse debt 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.

The gain or loss on the surrender of property in discharge of a non-recourse debt is calculated as the difference between the amount of debt owed on the property and the borrower’s basis in that property. This is also 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.

While it appears that borrowers with non-recourse loans are much better off 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.

Debtors who are insolvent at the time the debt is discharged. The amount of COD income that may be excluded is equal to the amount that a debtor is insolvent. 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.

For the discharge 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.

Typically there is an overall positive effect when renegotiating commercial real estate debt with your lender yet it’s imperative to assess all of the tax implications before completing the deal. Consult your tax advisors for guidance if you own commercial property and are considering such a negotiation this year or have already done so in 2009.

Dennis J. Fitzpatrick J.D. (dfitzpatrick@kaufmanrossin.com) is a tax principal with Kaufman Rossin. a leading CPA firm in the Southeast

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