Real Estate Borrowers Should Avoid Cancellation of Debt Income

Inflation has since cooled from its high of almost 9.1% in June 2022. But higher-for-longer interest rates and popularity of remote work has severely damaged the real estate industry—especially commercial real estate in urban areas. Higher inflation and interest rates have increased operating costs and debt service payments, also reducing real estate cash flows and property values.

The combination of higher operating costs, higher debt service and lower property values has made it difficult for real estate owners to refinance their maturing debt. This is predicted to produce more foreclosures and higher debt workouts.

Real estate lenders and borrowers need to prepare for the wave of debt maturity. Lenders will either need to renegotiate the maturing debt or start foreclosure proceedings. In this environment, $929 billion in commercial real estate debt will come due this year. Tax practitioners should advise borrowers and lenders how to handle potential tax complications.

Borrowers

Borrowers should aim to avoid any transaction that will result in cancellation of indebtedness income, or CODI.

CODI is the tax term for when income is realized by a borrower when all or part of its debt is actually canceled or is deemed canceled for tax purposes. Borrowers generally wish to avoid CODI because unless an exception applies, they will have taxable income without receiving cash from the transaction to pay the resulting income tax.

As it is more likely a borrower will have CODI if either the existing or new debt is deemed to be publicly traded, your first step as a tax adviser is to confirm that neither the existing debt nor the new debt will be treated as publicly traded.

Once you conclude that, you can advise your client to negotiate changes to maturity dates and interest rates rather than to the principal amounts—that is, the amount of the loan still outstanding. This will allow the deemed exchange to not result in CODI.

If the debt is deemed to be publicly traded, you can advise the client to structure the changes to avoid significant modification treatment by meeting the safe harbors for changes in the yield to maturity or extension of maturity date.

If the transaction results in CODI, which is ordinary income, you can help your client explore whether they can meet the exceptions to CODI found in the Internal Revenue Code. For example, you may be able to demonstrate that they qualify for relief under the insolvency exception under Section 108(a)(1)(B), the qualified real estate indebtedness exception under Section 108(a)(1)(D), or the stock for debt exception under Section 108(e)(8).

If these exceptions aren’t available, you can advise your client of the exception for bankruptcy relief under Section 108(a)(1)(A).

Lenders

Real estate lenders want to obtain the maximum tax deduction for the difference between the amount of the loan outstanding and the amount they are repaid or deemed to have been repaid. This difference is known as a bad debt loss for tax purposes under Section 165 of the tax code. One way to do this is to claim a worthless debt deduction in the year the debt becomes uncollectible, in whole or in part.

If your client is in the lending business, a business bad debt can be claimed in the year it becomes partially or wholly worthless. The bad debt loss is treated as an ordinary deduction under Section 165.

Clients can document their activities to support that they are in the lending business. You can advise your client on the proper structure and how to monitor their activities to ensure that the bad debt loss won’t be subject to potential loss limitations under Sections 461(l) or 469.

If the client isn’t in the lending business, the debt must be wholly worthless in the year of the deduction and will be treated as a short-term capital loss. You can work with your client to document the worthlessness of the debt and the year it became wholly worthless. You also can help your client realize any existing short-term capital gains that can be offset by short-term capital losses.

Another approach for the lender to obtain a tax deduction for a bad debt is to enter into a “significant modification,” which is treated as a deemed exchange of the existing debt for a new debt. You should first determine your client’s tax basis in the debt and the tax consequences of a deemed exchange.

If the debt exchange would result in a gain, you would advise the client to avoid triggering a significant modification of the debt. If the debt exchange would result in a loss, you can work with your client to establish that either the existing or new debt is or will be treated as publicly traded.

Once you have confirmed it is publicly traded, you can advise your client to restructure the debt to meet the significant modification rules while avoiding the safe harbor exceptions. This would allow for a loss on the exchange.

You would then work with your client to confirm that they were in the lending business and that this debt was therefore dealer property. As such, the loss would be ordinary. Your client would then confirm they weren’t subject to the passive activity loss or the excess business loss limitations.

If the client wasn’t in the lending business, the loss would be a capital loss and possibly passive loss. As such, you would work with your client to realize passive income.

Approximately $929 billion of commercial real estate debt will come due in 2024, according to the Mortgage Bankers Association. To the extent borrowers are unable to fully repay or refinance this debt, both borrowers and lenders will need to consider the tax consequences of debt forgiveness or modification.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Craig Stern is managing director at Mazars USA with experience in real estate, investments, and transaction service.

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