Tax implications of cancellation of debt income for real estate companies and their owners
Debt income cancellation tax implications
Supply chain issues persist due to the Covid-19 pandemic. Russia’s invasion of Ukraine has brought additional instability.
Though experts are saying it will likely take several years before prices really start to fall, these factors are making it more challenging for companies to meet their monthly debt service payments, particularly for any with variable-rate debt. Given the state of the market, cancellation of debt (COD) might become more prevalent over these next few years.
COD occurs when debt has been forgiven or discharged without the obligation to repay the original loan proceeds. This can occur in a variety of ways:
- Related party debt acquisitions
- A significant modification to a loan
In general, if there’s COD income because debt is canceled, forgiven or discharged for less than the amount required to be paid, the amount of the canceled debt is taxable and should be reported as ordinary income in the year the cancellation occurs. The creditor should provide Form 1099-C, Cancellation of Debt, which reports the amount of COD income, date of the cancellation and other pertinent information.
If property secured the debt and the creditor takes that property in full or partial satisfaction, the property is treated as having been sold to the creditor. Tax treatment of the COD will depend on whether the creditor has recourse to the other assets of the debtor (recourse debt) or only recourse to the secured property (non-recourse debt).
- If the property is subject to recourse debt that’s forgiven, the transaction is bifurcated into a sale transaction and a COD transaction. The sale transaction results in capital gains or loss equal to the difference between the fair market value (FMV) of the property and its tax basis. The COD transaction results in ordinary cancellation of debt income (CODI) to the extent the adjusted issue price of the debt exceeds FMV. For example, if the property is secured by $100x of recourse debt, the FMV is $60x and the tax basis is $40x, and the creditor forecloses on the property and forgives the $40x balance, the company has $20x gain (FMV-Tax basis) and $40x CODI.
- If the property is subject to nonrecourse debt, the amount of debt that’s being forgiven is treated as part of the sales proceeds, and gain or loss on disposition of the property should be calculated. There’s no separate COD ordinary income component. Using the example above, the result would be $60x gain.
Amounts that meet the requirements for any of the following exceptions listed below are not deemed to be COD:
- Amounts canceled as gifts, bequests, devises or inheritances
- Amounts of canceled debt interest that would be deductible if company was on the cash basis
- A qualified purchase price reduction given by the seller of property to the original buyer
- Certain student loan discharges
Items listed below are exceptions to COD income inclusion in gross income:
- Bankruptcy (Title 11) – applies to corporations and individuals but not partnerships
- Insolvency – limited to amount of insolvency
- Qualified farm indebtedness
- Qualified real property business indebtedness (§108(a)(1)(D)) (Taxpayers other than C Corps) – limited to insolvency and tax basis of the property
- Stock or partnership interest issued in exchange for debt-exemption limited to FMV of partnership interest issued in exchange for debt
Generally, if canceled debt from income is excluded, certain tax attributes must be reduced by the amount excluded and reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.
These exclusions are only meant to be a deferral, and the required reduction in tax attributes must apply in a particular order, starting with:
- Net operating losses
- General business credits
- Minimum tax credits
- Capital loss carryovers
- Basis in the taxpayer’s property
- Passive activity loss and credit carryovers, and lastly
- Foreign tax credit carryovers
Companies (or their owners in cases of partnerships) or an individual can elect to reduce the basis of depreciable property first before reducing any other tax attributes that are governed by IRC Section 1017. By making an election to reduce basis first, other tax attributes can be preserved that may be more valuable. This basis adjustment with respect to a partnership is treated similarly to an IRC Section 743 step-down adjustment.
We expect to see more COD transactions in the near future. Contact us to connect with a Mazars real estate specialist for help or guidance with your tax planning.