The commercial real estate market is in the process of adjusting to lower property valuations.1 Much recent focus has been on office buildings, and the fallout from enduring reductions in occupancy associated with remote and hybrid work models.2 However, the improbability of interest rates returning to pre-pandemic levels any time soon, loan maturity dates, and other factors, indicate that other sectors of the commercial real estate market are likely to experience challenging adjustments as well.3
The basic dynamic of course is that an owner-borrower experiences a reduction in current rental income / collections, that leads to an inability to service the loans (mortgages) encumbering the owner-borrower’s property, and projections indicate that the reductions in rental income / collections will be persistent. That then leads to a reconsideration of property valuations, and the ability to service outstanding loan (mortgage) obligations through maturity, and inevitably negotiations with lenders. Those negotiations often involve consideration of various workout strategies, including the prospect of canceling or forgiving, and / or foreclosing on, some or all of the loan (mortgage) obligations (depending on the circumstances).
When negotiations with lenders result in the cancellation or forgiveness of real estate loan (mortgage) obligations, the amount canceled or forgiven often constitutes ordinary income for the owner-borrower (i.e., the mortgagor) for US federal income tax purposes.4 This type of income is often called “cancellation of indebtedness” or “COD” income. The prospect of COD income can materially affect the strategy for approaching workout negotiations, and the outcome from those negotiations.
There are exceptions to having to recognize COD income when a real estate loan (mortgage) is canceled or forgiven, and the technical analysis depends in part on whether the owner-borrower (mortgagor) has personal liability for the canceled or forgiven amounts (i.e., whether the loan is “recourse” as to such amounts). However, when applicable, the rationale generally is that a borrower (i.e., the owner (mortgagor) is better off economically when the obligation to repay the borrowed funds is canceled or forgiven, and so should be treated as realizing (and generally required to recognize) income at that time.
The underpinning of this rationale is that borrowers are not required to recognize income (i.e., are not treated as receiving taxable income) as a result of receiving borrowed funds - in light of the obligation to pay the funds back to the lender.5 Instead, in the ordinary course of commercial activities, a borrower generally will earn income from the activities that are conducted in connection with spending the borrowed funds, will pay US federal income tax on such income, and then use the after-tax balance of such income to pay off the loan. If the obligation to repay the loan is canceled or forgiven, the borrower would not have recognized income upon receipt of the borrowed funds, would have enjoyed the opportunity to spend the borrowed funds, and then would essentially thereafter avoid the necessity of earning income to repay the then remaining unpaid balance of the loan.
In the absence of imposing some kind of tax consequence on the borrower at the time of cancellation or forgiveness, the borrower would be allowed to receive and spend the borrowed funds without incurring any tax consequences on either the “front end” or the “back end” (from ordinary course commercial activities). That would essentially create an imbalance from a US federal income tax perspective (i.e., there would be no trade-off for being allowed to receive and spend the borrowed funds without having to include such funds in taxable income). So, the requirement to recognize COD income (i.e., to include it in the borrower’s taxable income) steps in to provide the balancing factor.
If the borrower is classified as a partnership or S corporation for US federal income tax purposes, the consequences associated with a cancellation or forgiveness of loan obligations, and any associated COD income, generally are borne by its partners or shareholders. In that case, COD income flows through to the borrower’s partners or shareholders, and is reported as taxable income at their level.6 The flow through increases the outside tax basis that the partners or shareholders have in their ownership interests in the borrower by the amount of the COD income allocated to each partner or shareholder.7 That is somewhat of an ancillary consequence, but can be useful in connection with mitigating other taxable events associated with or following workout negotiations.8
There are various exceptions and limitations to the requirement to recognize COD income.9 One important exception applies when the borrower is the subject of a bankruptcy proceeding under title 11 of the United States Code (including a liquidation under Chapter 7 or a reorganization under Chapter 11), and the discharge or cancellation of the loan occurs pursuant to a plan approved by the court (or is otherwise granted by the court).10 Another important exception applies when a discharge or cancellation occurs outside of a bankruptcy proceeding, and the borrower is insolvent at such time (in which case, the exception applies up to the amount of the insolvency).11
And yet another important exception is applicable to certain real estate investors who make an election with respect to the cancellation or forgiveness of a loan incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business (i.e., “qualified real property business indebtedness”).12 If an exception is applicable, the COD income is excluded from taxable income.13 When an exclusion is available, that generally is a relief to borrowers. However, there is a trade-off for such exclusion. In that case, the remaining tax attributes of the borrower (including net operating losses, tax credits, and adjusted tax basis of assets) have to be reduced by the amount of the excluded COD income.14 Depending on the circumstances, such tax attribute reduction can be important in shaping workout negotiations and post-workout opportunities.
If there is no personal liability for the canceled / forgiven amounts (i.e., if the loan / mortgage is “nonrecourse” as to such amounts), the analysis is a bit different. In such case, the canceled / forgiven amounts are treated as additional proceeds from a deemed sale or exchange of the property at the time of cancellation / forgiveness. There is no COD income with respect to such amounts. The balancing factor instead is the deemed receipt of additional sales proceeds. That can result in taxable income, and have material consequences. However, it is not technically COD income, and thus not subject to the complexities associated with COD income.
There is much to consider when confronted with the prospect of entering into workout negotiations with lenders. One component of planning a strategy around such negotiations is consideration of the fallout that can occur from any COD or other income that could or will result from various approaches. Such fallout will no doubt be a central topic in pending discussions confronting the owners of commercial real estate as valuation adjustments roll through the market in the coming months and years.
We advise owners, developers, investors, lenders, and trustees in the commercial real estate market (and other sectors of the real estate markets), including in connection with workout negotiations, out-of-court restructurings and reorganizations, and bankruptcy proceedings.
1 See, M. Luck, “Historic Complex Downtown Foreclosed”, Houston Chronicle
(August 8 2024); M. Haag, “Major Markdown on Manhattan Site”, NY Times (August 2 2024); P. Grant, “A Real-Estate Fund Industry Is Bleeding Billions After Starwood Capped Withdrawals”, WS Journal (July 1 2024); M. Goldstein, “Banks Quietly Dumping Real Estate Loans”, NY Times (June 27 2024); M. Goldstein, “Bargain Hunters Snap Up Empty Office Buildings as Woes Rise”, NY Times (June 14 2024); J. Rennison and J. Creswell, “Owners Face More Woes as Buildings Stay Empty”, NY Times (June 8 2024) (“Owners Face More Woes”); H. Gillers, “Commercial Property Meltdown Clobbers Pension Funds”, WS Journal (May 31 2024); P. Grant, “Chicago to Offer Most Generous Subsidies in U.S. to Save Its Downtown”, WS Journal (May 28 2024).
2 Recent data indicates that vacancy rates in U.S. office buildings are around 22%, though it appears that much of that could be focused on just 10% of the office buildings in the U.S. See, Owners Face More Woes (supra). It is estimated that there are $750 billion of loans / mortgages encumbering U.S. office properties, and that about $200 billion of those will mature during 2024. Id,
3 The commercial real estate market often is described as comprising four main sectors: (a) office; (b) industrial; (c) multifamily; and (d) retail. See, J. Chen, “Commercial Real Estate Definition and Types”, Investopia (July 31 2023); R.H. Beck, “What is commercial real estate?”, Bankrate (September 23 2022).
4 This consequence is specifically provided by Section 61(a)(11) of the Internal Revenue Code (the “Code”).
5 The theory is that the borrower’s obligation to repay the loan proceeds to the lender means that the borrower’s receipt of the borrowed funds does not constitute an economic accretion to wealth that should be treated as income for US Federal income tax purposes. See Commissioner v. Tufts, 461 U.S. 300 (1983).
6 This consequence occurs pursuant to Section 701 of the Code, in the case of tax partnerships, and Section 1366 of the Code, in the case of S corporations. In the case of tax partnerships, COD income is part of “bottom line” income reported to partners under Section 702(a)(8) (and determined pursuant to Section 703). In the case of S corporations, COD income is part “nonseparately computed income or loss” under Section 1366(a)(2). .
7 This consequence occurs pursuant to Code Section 705, in the case of tax partnerships, and Code Section 1367, in the case of S corporations. In the case of S corporations with accumulated earnings and profits, COD income also is included in the accumulated adjustments account under Code Section 1368.
8 If the borrower is a classified as a partnership for US federal income tax purposes, there is another layer of consequences for its partners. Those consequences are related to the pass / flow through nature of partnerships, and the ability for partners to include amounts borrowed by partnerships in the outside tax basis that the partners have in their ownership interests in the partnership. IRC §§705(a), 722 & 752(a). When a partnership’s obligation to repay borrowed amounts is cancelled / forgiven (or otherwise satisfied), the partners are deemed to receive a distribution from the partnership in the amount that is cancelled / forgiven (or otherwise satisfied). IRC §752(b). If the amount of the distribution that a partner thereby is deemed to receive exceeds the partner’s outside tax basis in the partner’s ownership interest in the partnership at such time (which is common when, for example, a partnership has prior tax losses derived from the expenditure of borrowed funds), the partner realizes taxable income in the amount of the excess. IRC §731(a)(1). This result is separate and in addition to COD income consequences. So, a partner in a tax partnership can realize both COD income and “Section 752” / “deemed distribution” income upon cancellation / forgiveness of a tax partnership’s obligation to repay borrowed funds.
9 These exceptions and limitations arise under Code Section 108.
10 This exception technically applies when the “taxpayer” is the subject of bankruptcy proceedings. See IRC §108(d)(2). If the borrower is a so-called “disregarded entity” or a “grantor trust”, the owner of the disregarded entity or grantor trust must itself be subject to the jurisdiction of the bankruptcy court as a debtor (as defined in 11 U.S.C. 101(13)) in order take advantage of this exception. Treas. Reg. §1.108-9(a). If the borrower is a tax partnership, a partner must be subject to the jurisdiction of the bankruptcy court as a debtor in order take advantage of this exception. Id. at (d). As a result, this exception can have limited utility in such instances. On the other hand, if the borrower is a S corporation, all that is required is that the borrower be subject to the bankruptcy proceedings. See IRC §108(d)(7).
11 This exception technically applies only to a “taxpayer” that is insolvent. See IRC §§108(a)(1)(B) & (d)(3). If the borrower is a disregarded entity or a grantor trust, that means that the owner of the disregarded entity or grantor trust must itself be insolvent in order take advantage of this exception. Treas. Reg. §1.108-9(a). Similarly, if the borrower is a tax partnership, a partner must be insolvent in order take advantage of this exception. Id. at (d). As a result, this exception also can have limited utility in such instances. On the other hand, if the borrower is a S corporation, all that is required is that the borrower be insolvent. See IRC §108(d)(7). The determination of “insolvency” can be complicated. See IRC §108(d)(3). If the borrower is a disregarded entity, grantor trust, or partnership, debt of the borrower with respect to which no owner or partner has personal liability (i.e., debt that is non-recourse to the owner or partners) is taken into account to a limited extent. See Rev. Rul. 2012-14 and Rev. Rul. 92-53. That is helpful, but adds to the complexity of determining whether the insolvency exception is applicable in such instances.
12 This exception does not apply to C corporations. IRC §108(a)(1)(D). A somewhat more lenient standard applies to debt in place prior to 1993. IRC §108(c)(3).
13 If the borrower is a S corporation, the excluded amount does not flow through to increase the adjusted basis of its shareholders in their shares of stock in the corporation. IRC §108(d)(7)(A).
14 The adjustment is made after the determination of tax for the year in which the cancellation or forgiveness occurs. IRC §108(b)(4)(A). If the borrower is a disregarded entity, grantor trust, or partnership, attribute reduction technically occurs at the owner or partner level. IRC §108(d)(6). In the case of a borrower that is a disregarded entity or grantor trust, that essentially implicates any tax attributes held by the borrower as a commercial matter (such as the adjusted tax basis of assets held by the borrower) because the owner is treated as the “taxpayer” in such instances. If the borrower is a partnership, the assets of the partnership are not directly implicated, but might be affected indirectly depending on the circumstances and other consequences from the workout negotiations. Also, in the case of “qualified real property business indebtedness”, attribute reduction is limited to the adjusted basis of the taxpayer’s depreciable real property. IRC §108(c)(1)(A).
