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Smart Strategies for Restructuring Debt

September 25, 2023

The Tax Nuances of Debt Modification Series Part 2

As seen in Commercial Observer

The real estate sector is presently encountering exceptional difficulties as the era of low interest rates and minimal inflation has concluded, with lingering economic uncertainty casting a shadow. In a distressed real estate market, owners and lenders may consider loan term renegotiations to maximize their cashflow, however this may bring unexpected tax consequences. For part 2 of The Tax Nuances of Debt Modification series, we will review tax strategies for specific situations including bankruptcy, insolvency and Qualified Real Property Business Indebtedness (QRPBI).

To briefly recap, real estate owners may modify their debt to better manage their cashflow by using strategies including:

  • Extending the loan’s maturity date;
  • Changing the interest rate;
  • Exercising conversion features; or
  • Changing fixed payment of principal to contingent amounts.

While potentially valuable, these modifications may come at a cost. When the original debt’s issue price is higher than the new debt’s issue price, the taxpayer usually recognizes Cancellation of Debt (COD) income. In other words, they may realize a substantial taxable gain even though they have not received any cash proceeds.

That said, there are provisions that allow taxpayers to exclude or defer COD income. The following section focuses on COD income with respect to bankruptcy, insolvency and QRPBI. Although, it is important to note that that QRPBI does not apply to developers.

Bankruptcy and Insolvency

In bankruptcy, taxpayers do not have to include forgiven debt as income. However, taxpayers that are insolvent, but are not bankrupt, can only exclude COD income up to the amount by which their debts are greater than the value of their assets.

Both the bankruptcy exception and the insolvency exception apply at the partner level.

Reduction of tax attributes

Being able to exclude COD income in the event of bankruptcy or insolvency comes at the cost of lowering certain tax benefits, generally in the following order:

  1. Net operating losses;
  2. General business credits;
  3. Minimum tax credits;
  4. Capital loss carryovers;
  5. Basis of the taxpayer’s property;
  6. Passive activity loss and credit and carryovers; and
  7. Foreign tax credit carryovers.

However, a taxpayer can elect to first reduce the basis of depreciable property, but in many cases, the immediately available net operating loss or credit will be more valuable than depreciation expenses spread out over the life of the property.

Qualified Real Property Business Indebtedness

Subject to limitations, taxpayers who are neither bankrupt nor insolvent may have the option to exclude COD income from the discharge of QRPBI. Note, this election is not available to C corporations.

QRPBI is defined as debt that is:

(a) incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property; and

(b) was incurred or assumed before January 1, 1993, or was incurred or assumed after such date to acquire, construct, reconstruct, or substantially improve such property.

As with the bankruptcy and insolvency exceptions, the QRPBI exclusion applies at the partner, rather than the partnership, level.

To exclude income from the discharge of QRPBI, the taxpayer must make a valid election. The amount of excluded income reduces the basis of the taxpayer’s depreciable real property, which is not limited to the property that was secured by the debt.

The fact that the debt must be secured by real property can create challenges when dealing with LLCs. In large acquisitions, it is typical to see multiple tranches of debt, with varying maturities, interest rates, and degrees of risk. Under an IRS safe harbor rule, debt backed by full ownership in a disregarded entity satisfies the “secured by” requirement under certain conditions, but it appears that the safe harbor allows for only one level of debt to be secured by a disregarded entity interest.

Limitations on Excludable Income

Taxpayers have two limits on how much forgiven debt income they can exclude for tax purposes. In general, the amount of income excluded cannot exceed the lesser of:

  1. The excess of the outstanding debt principal (immediately before the discharge) over the fair market value of the real property securing the debt (reduced by the principal amount of any other qualified real property business debt secured by the property); or
  2. The aggregate adjusted bases of all depreciable real property held by the taxpayer determined as of the first day of the tax year following the discharge (or, if earlier, the property’s disposal date)—the overall limitation.

When refinancing, relief is available as long as the new loan amount doesn’t exceed the amount of the original business property debt. If a partnership borrows against real property and distributes all of the additional proceeds to its partners, the additional borrowing can’t be treated as QRPBI.

Seek Advice Before You Need It

Navigating the COD income rules can be difficult. Taxpayers need to exercise caution in assessing whether a “significant modification” of debt occurs, potentially leading to a deemed re-issuance of the debt. It is also important to test the revised debt to determine whether it is treated as debt or ownership in the company. For more information on significant modifications, read part 1 of this series by clicking here.

While debt modification can offer valuable advantages, meticulous advance planning is critical, and initiating research on your options can never begin too early. It is important to consult with your trusted advisors if you are considering debt modification to best understand the tax strategies available to you. For more information, please contact Aleksander Dziedzic, Tax Partner in Anchin’s Real Estate Group.