With distant work fashions prevailing and plenty of tenants gravitating to Class A buildings with facilities, there are quite a lot of Class B and Class C property house owners with excessive emptiness charges and important imminent capital critically contemplating giving the keys to their lenders in trade for relieving the debt obligation.
Nonetheless, even for properties with a dismal monetary outlook, debtors should take into account the potential detrimental tax penalties of phantom acquire and cancellation of debt.
Phantom Acquire
Challenge: A lender can drive a switch of title by a foreclosures motion and a property proprietor can switch the title to a lender voluntarily by a deed-in-lieu of foreclosures. Nonetheless, both of those transactions is taken into account a sale of the property for federal and state revenue tax functions (and native switch tax functions in most jurisdictions).
Below federal tax legislation, the proprietor is handled as promoting the property for an quantity equal to the excellent debt. When nonrecourse debt is concerned, the reported taxable acquire can be an quantity equal to the debt over the adjusted tax foundation within the constructing.
For buildings owned for a protracted time frame which have been considerably depreciated (and people acquired extra just lately as substitute property for older depreciated properties in a like-kind trade), a property proprietor may find yourself recognizing important taxable acquire with no money proceeds.
Against this, if recourse debt is concerned, surrendering property is handled as two separate transactions for tax functions, leading to phantom acquire and “cancellation of debt” (“COD”) revenue. Phantom acquire can be realized to the extent that the property’s honest market worth (FMV) exceeds the debtor’s adjusted tax foundation (sale therapy). COD revenue can be realized to the extent that the principal quantity of the debt exceeds the property’s FMV as a result of that a part of the recourse debt has primarily been forgiven (much less any quantities paid as a part of the recourse obligations).
For instance, a debtor transfers an asset with a FMV of $12 million in discharge of $15 million of recourse debt, and the debtor’s tax foundation within the asset is $7 million. The debtor will notice $3 million of COD revenue ($15 million of recourse debt minus FMV of $12 million), and $5 million of phantom acquire ($12 FMV of the property much less $7 million adjusted tax foundation within the property).
With both nonrecourse or recourse debt, the phantom acquire is usually taxed at favorable long-term capital features charges (assuming the property has been held for no less than one 12 months).
Options: There are only a few methods to defer phantom acquire.
One chance is doing a like-kind trade into a brand new property. Nonetheless, an trade of property with no money at closing means the proprietor should discover recent fairness to purchase a substitute property. Another choice is to switch title in a 12 months when the proprietor has accrued losses from different properties to offset any phantom acquire.
Cancellation of Debt
Challenge: It might be worthwhile to debate the potential for decreasing or restructuring the debt.
Nonetheless, if a lender agrees to scale back the excellent principal stability, the property proprietor should report COD revenue in an quantity equal to the debt discount. That is the case no matter whether or not the debt is nonrecourse or recourse. COD revenue is taxed on the increased strange revenue charges.
Options: Discount of Foundation. A property proprietor can defer COD revenue by electing to scale back the premise within the constructing. This solely applies if the debt was used to accumulate or enhance the constructing and the debt presently exceeds its honest market worth. If the constructing depreciable foundation (land is excluded for this function) isn’t excessive sufficient to scale back the whole quantity of the COD revenue, the proprietor could cut back the depreciable foundation of different buildings it owns. Observe that this ends in decrease depreciation deductions sooner or later, so decreasing the depreciable foundation in a constructing successfully amortizes the popularity of the COD revenue over future years.
Chapter and Insolvency. A borrower that’s both bancrupt or in chapter can exclude COD revenue to the extent the borrower is bancrupt, or the debt is discharged in chapter. Nonetheless, the borrower should cut back sure tax “attributes” comparable to internet working losses, the adjusted tax foundation of the constructing, and different depreciable belongings.
COD Earnings and Partnerships. Since partnerships are thought of “go by” entities, any COD revenue ensuing from restructuring partnership debt is handed by to the companions. Federal tax legislation requires that to reap the benefits of the chapter and insolvency guidelines above, the companions (not the partnership) should be bancrupt or obtain the discharge in chapter.
The underside line: perceive the tax implications of handing the lender these keys earlier than performing on it. In sure instances, growing a plan with the lender can avert unanticipated, detrimental tax penalties and assist house owners preserve management of their properties—an answer each events can purchase into.
Scott Drago is a managing director within the Enterprise Tax Advisory group inside the Actual Property Options observe at FTI Consulting, Inc., in New York. Contact him at [email protected]. Stephen Bertonaschi is a senior managing director within the Enterprise Tax Advisory group inside the Actual Property Options observe at FTI Consulting, Inc., in Roseland, New Jersey. Contact him at [email protected].
