Tax Implications of Debt Cancellation, Foreclosures & Short Sales

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HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

HOST: Welcome to this edition of the Cherry Bekaert Tax Beat podcast. Today we are talking about the unpleasant tax cost of cancellation of debt (COD) transactions.

HOST: With interest rates rising and commercial space vacancy rising, we are seeing more lenders taking action to cut their losses and engaging in conversations with their real estate clients in particular.

HOST: Joining today in our conversation is a slew of people from Greenville, South Carolina. First I have Mark Cter, who is the head of our real estate and construction industry practice.

MARK COOTER: Good. Glad to be here.

HOST: Also Laura Turner, a partner in our Greenville office specializing in real estate.

LAURA TURNER: Good, thanks for having me. I have to admit I always thought a murder podcast would be the first podcast I would be on, but I'm just as excited to be here today.

HOST: You have teammates in Greenville to explore those options for—I'll just leave it at that.

HOST: And as always, joining me is Sarah McGregor. Sarah, how's life treating you these days?

SARAH MCGREGOR: Life is good. I'm not in Greenville today; I'm up in the mountains of North Carolina where it's cool and breezy and pleasant during this hot summer. I'm also within arm's length of Laura, so there's a benefit.

HOST: Very good. Let's hit it. A little background on this topic: certain sectors of commercial real estate and operating businesses are dealing with lenders who are concerned about the loans they have made. Higher interest rates, commercial space declines, declines in value, and significant bank failures are all factors that have been playing into this.

HOST: On top of that, we're seeing foreclosure, short sales, conversions, and equity issues. Tax flow can be very complicated in this area, so we're going to get into some of those. Mark, what's the very basics of the basics? What is cancellation of debt and when are the most common occurrences?

MARK COOTER: Cancellation of debt typically occurs when a borrower is relieved of a liability by a lender. This situation commonly arises when liabilities exceed the value of the underlying asset and the lender provides relief to the borrower.

MARK COOTER: Relief can be provided in different circumstances. You might see an outright discharge where the lender, in negotiation for refinance, reduces the loan and the borrower continues to own the asset. You might see an asset foreclosure, which happens when the asset is given up to the lender. There might be a modification of debt that functions as an outright discharge, or an exchange for the debt or a purchase of the debt at a discount by another party.

MARK COOTER: There are several instances where COD arises, but it's primarily when a borrower is relieved from some portion of a liability.

HOST: That sounds pretty awful for a business or borrower who is in trouble financially, but the tax code does provide a few exceptions from recognizing this kind of income.

MARK COOTER: Yes. The code section we're talking about here is Section 108, which excludes COD from gross income in certain circumstances. Some common exclusions include Title 11 bankruptcy and insolvency, where the taxpayer has liabilities in excess of the fair market value of assets.

MARK COOTER: Another common exclusion is purchase-money debt reduction, where debt of the purchaser to the seller is reduced as an adjustment to the purchase price. The last one to mention is qualified real property debt, which is debt related to real property where you would adjust the basis of the real property.

MARK COOTER: Some of these are timing issues rather than permanent exclusions. Relief from income recognition through Section 108 is not always applied to the entity that is the borrower. The treatment depends on the type of entity involved.

MARK COOTER: In a C corp, the corporation is treated as the taxpayer. An S corporation has a unique situation where the exclusions and attribute reductions are applied at the S corporation level, although COD income then passes through to the S corporation shareholders. In a partnership, the income exclusion and attribute reduction are applied at the partner level, and the COD income passes through to the partners.

MARK COOTER: That is an important piece as it relates to partnerships because if you've got an insolvency exclusion, you need to look at the partnership level rather than the entity level. Also, if COD is passed out to the partners, that might lead to planning opportunities we'll discuss later.

HOST: Mark, a follow-up clarification: we're talking about attribute reduction. This COD exclusion is not a totally free exclusion. Explain that in more detail.

MARK COOTER: In most cases, when we say there's an exclusion event, we're talking about income being deferred and the income is deferred by reducing certain tax attributes inside the entity or at the partner/shareholder level. Inside a C corp, you might see a reduction in net operating losses, carryforward credits, or capital losses carried forward.

MARK COOTER: For partnerships and S corporations, you might see a reduction in basis of property or passive activity loss carryovers. The IRS expects you to reduce certain tax attributes before something is fully forgiven for tax purposes. It's a layer-cake approach: income is deferred until the attributes that would have absorbed that income are used.

MARK COOTER: You will pick up the income later, either when the entity generates income again or when the asset is sold and you have cash from a sale that helps offset the tax cost at that point. That's an important distinction when evaluating the exclusion.

HOST: Laura, can you talk about the difference between a foreclosure or short sale versus debt modifications or outright discharges?

LAURA TURNER: Yes. Foreclosures and short sales occur when the property is no longer in your possession. A foreclosure is involuntary, and a short sale is voluntary. You may have COD in those situations, but exclusions like insolvency would apply after the transaction took place.

LAURA TURNER: Debt modification is an area with many complexities and can create COD if the modification is deemed significant. The IRS provides bright-line tests for modification significance if you're involved with one.

LAURA TURNER: An outright discharge occurs where you keep possession of the property but have an implication from the fact that the debt was forgiven. There are different treatments and nuances depending on whether the debt is recourse or nonrecourse. Recourse can create COD income, while nonrecourse can still create income but typically would not be treated as COD income.

HOST: Mark, frequently there is a guarantor who signs on to a loan, making it recourse to that guarantor. What is the role of tax exposure for an individual who signed a guarantee?

MARK COOTER: As a guarantor, you might have to contribute additional funds to help settle an obligation when the lender seeks to resolve a loan. If the guarantor makes whole the lender for their portion of the loan under the guarantee, that contribution is generally treated as a capital investment.

MARK COOTER: The guarantor would be able to take a capital loss on that contribution, subject to capital loss limits. If the capital loss is not absorbed in the same year, capital loss rules limit deductibility against ordinary income to $3,000 per year, with the remainder carrying forward until used.

MARK COOTER: If the guarantor is paying at the time of a short sale or foreclosure, the sale transaction might generate a capital gain that could offset the capital loss. If the guarantor is also a partner in the partnership or a shareholder in the transaction, those interactions must be analyzed and planned for.

HOST: Final question and final answers and comments. Laura, what planning ideas are you recommending to clients facing foreclosures and debt modifications with their lenders?

LAURA TURNER: My biggest piece of advice is to include your tax advisor early in the process rather than waiting until after a decision has been made. The earlier we get involved, the more we can partner with you to understand options and potential tax consequences and help you make better decisions up front.

HOST: Mark, what do you have to add?

MARK COOTER: I second what Laura mentioned. There can be tax elements in the negotiation that result in a much better outcome if addressed beforehand. Different rules apply to different entity types, so understanding whether a loan sits in a partnership, C corporation, or S corporation is critical.

MARK COOTER: Partnerships may offer advantages to partners if there's COD income, and you should understand those effects before passing items through to partners so they know what to expect individually. Planning is important both in negotiations with the lender and in communications with investors.

HOST: I have one more point: with enough lead time, you can sometimes move where forgiveness is triggered by transferring or selling notes among parties. It's not always possible, but sometimes you have some control over where the forgiveness is triggered to achieve better tax results.

HOST: Sarah, any final comments?

SARAH MCGREGOR: We've focused on the borrower facing these challenges, but this environment also creates opportunities for short-sale buyers. There may be investment opportunities for those with cash to help out borrowers in difficult positions with their lenders.

HOST: That's a wrap on today's discussion about cancellation of debt income. A quick disclaimer: we are not providing tax advice on this podcast. Please consult with your tax advisor, hopefully at Cherry Bekaert, about your specific tax issues or to discuss information from today's podcast.

HOST: For the firm's latest guidance and materials on this and other tax and business topics, check out the firm's website at cb.com.

HOST: This concludes today's podcast. Please like, share, and subscribe. Thank you, Laura and Mark, and thank you to our listeners for spending your time with us. Let's call it a day and go forth.

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