When financial conditions are adverse, commercial lenders may be willing to renegotiate existing loan agreements, in some cases, forgiving a portion of an outstanding loan in exchange for other concessions. There are significant tax implications if the loan is reduced or forgiven, though. Under current law, a borrower is required to pay taxes at ordinary income rates, currently as high as 37%, on the amount of debt reduced, discharged or canceled, an amount referred to as cancellation of debt income or COD.
If the income and the loss matched for tax purposes, all would be well. Unfortunately, the COD is recognized immediately and the loss on the associated property is only recognized once the building is sold.
While debt forgiveness constitutes income for tax purposes, the forgiveness often occurs because the borrower is suffering an economic loss, often on the asset associated with the loan. Congress is looking for an alternative solution that will continue to promote economic recovery, while at the same time discouraging abuse of tax laws when financial conditions improve.
Options for relief
Based on historical precedent, Congress is likely to provide some relief for this conundrum, but the form it takes, and how timely it will be, remain unclear. There are likely three options to help commercial property owners facing tax on loan forgiveness: The first would be to completely forgive any income tax on debt forgiveness income. That is essentially how Congress handled the Paycheck Protection Program loan forgiveness.
The second calls for deferring recognition of the COD income for a limited period of time, based on a provision adopted during the mortgage crisis.
The last option would forgive COD income to the extent the taxpayer agrees to reduce the tax basis of his assets—effectively converting the immediate COD income into reduced losses or increased gains— but only when the assets are later sold or written down. This option, referred to as attribution reduction, is being advocated by leading real estate interests, and RSM tax professionals have been providing technical assistance.
“No one is asking for a handout, just to defer some of the pain until later when there's going to be some gain,” says Don Susswein, principal of RSM’s Washington National Tax, who has been working on the last option as a member of Real Estate Roundtable’s Tax Policy Advisory Committee. The committee is the leading Washington, D.C. representative of the real estate industry.
The Real Estate Roundtable and others have made clear the tax relief that the attribution option provides is temporary. The federal government will still collect taxes on COD when the borrower gains financial footing, and subsequently, sells the property. The recommendation further protects smaller property owners by excluding the recognition of any COD income up to $250,000.
Under current law, the attribution reduction election that does exist can only be made by individuals. But many properties are held in partnerships within multitier structures and real estate private equity funds, creating significant distance between the entity that owns the property and individual investor in the asset. The revised attribution reduction option would give partnerships the opportunity to exclude COD income to the extent of the basis in their own assets, rather than put the burden on those individual investors.
In today’s pandemic-driven environment, the financial difficulties facing commercial real estate are daunting. A provision to facilitate loan workouts by rationalizing the tax rules governing debt forgiveness could be very helpful in promoting a faster economic recovery.
Says Susswein: “Congress is going to have to do something about [COD]. Or else people are going to be unfairly and inappropriately taxed as if they were making money, even though they are actually losing money.”