A result of the pandemic is that employees no longer travel to their offices every day of the week. This new reality has put pressure on commercial real estate owners as tenant leases come due — there is even talk of a mortgage debt Armageddon as large numbers of commercial property mortgages will be coming due soon. That means that this is a good time to review the cancellation of debt rules regarding when cancellation of debt is taxable and when there are exceptions.
Generally, discharge of debt, or debt forgiven or canceled by the lender, is taxable income. The taxable amount is the difference between the amount of the existing debt and the amount that is ultimately paid.
A loan modification can also be considered a cancellation of debt income if deemed “significant”. There is a two-part test to determine if a loan modification is significant. First, were the terms of the debt instrument modified and, second, was the modification significant?
Tax significance is determined by examining different variables. Regulations help define modifications, which can occur by amending the terms of a debt instrument or by exchanging one debt instrument for another.
A modification is not:
• An alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument.
• Borrower’s nonperformance, although the agreement of the lender not to exercise its remedies under the debt instrument may be a modification.
• The failure of the lender or borrower to exercise an option in the loan agreement.
The IRC Sec. 1001 regulations provide for the following loan changes that would make a modification significant:
• Loan yield: A change in yield of more than the greater of 25 basis points or 5% of the yield of the unmodified loan.
• Timing of payments: An extension of five years or 50% of the original term of the loan.
• Change in obligor or security: Substitution of a new obligor on a recourse loan.
• The nature of a debt instrument: Modification of the loan such that it is no longer considered debt for federal income tax purposes.
• Changes to accounting or financial covenants: Tied to a borrower payment that affects the loan yield.
Cancellation of debt income (COD) is taxable as ordinary income. IRC section 108 provides for specific exclusions:
• Bankruptcy exclusion: Debt discharged from bankruptcy is excluded from gross income.
• Insolvency exclusion: Debt that is discharged can be excluded form gross income if at the time of the discharge the taxpayer is insolvent. Insolvency is the amount in which the taxpayer’s liabilities exceed the taxpayer’s assets. For both bankruptcy and insolvency, the taxpayer must reduce tax attributes for the amount of the COD excluded from income.
Tax attributes are to be reduced in the following order: net operating losses, general business credit, Minimum tax credit, capital loss carryovers, basis in property, passive activity loss and credit carryovers and foreign tax credits.
Instead of reducing tax attributes, taxpayers could elect to reduce the basis first if it would benefit them.
Qualified Real Property (QRP) indebtedness exception is debt incurred or assumed by the debtor in connection with real property used in a trade or business. There are two limitations on how much COD can be excluded:
• The amount excluded cannot exceed the outstanding principal of the QRP property business indebtedness over the net fair market value of the qualified real property before the debt discharge.
• The amount of canceled QRP debt that can be excluded cannot exceed the total adjusted bases of depreciable property held immediately before the debt cancellation.
The tax consequences can differ depending on multiple factors, such as whether the debt is recourse or non-recourse.
Taxation of loan modification is a complex area. If you are in a situation where a debt may need a modification or there is a chance of foreclosure, it is well advised to familiarize yourself with all the rules, as there is an opportunity for some tax planning to minimize the tax ramifications of such transactions.
Stephen Gilman
Partner, Tax & Business Services
Marcum LLP
53 State Street, 17th Floor
Boston, MA 02109
(617) 807-5015
stephen.gilman@marcumllp.com
