The tax relief commercial real estate investors may need after Covid-19

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The COVID-19 pandemic has had a dramatic impact on commercial real estate values ​​and in some cases has caused the property to no longer be able to sustain the debt it is burdened with. Declining commercial property values ​​have forced many owners to restructure their debt. However, forgiveness of a portion of the resulting debt does not automatically result in federal taxable income. Favorable rules, which have been put in place for taxation years after 1992, could allow the cancellation of debt income to be deferred for federal income tax purposes even if the taxpayer is not bankrupt or insolvent, as is normally the case.

Taxable income is closely related to when a taxpayer receives an economic benefit. So it makes sense that if you previously had a bank loan of $100,000 and the bank lowers the principal balance to $80,000, then your economic benefit of $20,000 should be included in taxable income. Reducing the principal of debt is often referred to as debt relief or debt cancellation. Under certain circumstances, the Internal Revenue Code allows debt cancellation income to be excluded from a taxpayer’s income in cases of a Title 11 (bankruptcy) or where the taxpayer is insolvent. Insolvency is defined as the excess of liabilities over the fair market value of assets. The ability to declare insolvency at the entity level is limited to C and S corporations. For partnerships, the most common type of entity for real estate, insolvency must be measured at the partner level individual. This can be a problem because often the individual partners are solvent (i.e. not insolvent).

However, being insolvent or bankrupt is not the only way for taxpayers involved in real estate to exclude debt income cancellation. Provided the taxpayer is not a C corporation, write-off of debt income may be excluded if discharged debt is considered indebtedness of eligible real estate businesses (QRPBI). The QRPBI is a debt contracted or assumed by the taxpayer in relation to real estate used in a trade or business and which is guaranteed by this property. For property acquired on or after January 1, 1993, the QRPBI includes debt used to acquire, build, rebuild, or substantially improve real estate. Whether a taxpayer is engaged in a trade or a business is not always easy to answer and lease agreements using a triple net lease should be carefully reviewed to ensure they qualify as a trade. or business.

As always, there is a catch. The IRS is not going to allow an exclusion from taxable income out of the goodness of its heart. Instead, the Internal Revenue Code essentially permits an exchange; in exchange for an exclusion from cancellation of QRPBI-related debt income that is not due to insolvency or bankruptcy, the rules allow a taxpayer to choose to reduce the tax base of their real estate depreciable under section 108(b)(5). The amount of the base exclusion and reduction is the excess of the outstanding principal amount of the debt less the FMV of the commercial property immediately before discharge. The FMV of the property is reduced by any other eligible real estate debt secured by the property.

Let’s take an example. Suppose Julia acquires a building in 2018 that she uses in a trade or business. In 2021, the building is subject to a first mortgage of $110,000 and a second mortgage of $90,000. The FMV of the building in 2021 is $150,000. In 2021, Julia’s bank agrees to reduce the second mortgage debt from $90,000 to $30,000, resulting in the cancellation of the debt income of $60,000. The principal outstanding debt immediately prior to release was $90,000, which exceeds the FMV of the property less the first mortgage ($150,000 – $110,000) by $50,000. Therefore, Julia could exclude $50,000 of income and would only be required to include $10,000 of debt forgiveness income.

For Julie to ensure that the $50,000 is not included in taxable income, her aggregate adjusted depreciable real estate tax bases must be at least $50,000. The basic reduction, provided for in section 1017, will apply as of the first day of the taxation year following the year of the discharge (or immediately before the disposition if the property is sold before the end of the ‘taxation year). In our example, Julia would include the $10,000 of debt forgiveness income on her 2021 tax return and adjust her base in her real estate by $50,000 beginning January 1, 2022.

If the property is not held directly by an individual, but rather held by a partnership, the determination of whether the debt is QRPBI (and the application of the FMV limitation) is made at the level of the partnership. However, the decision on the basic reduction is taken and elected at partner level. This allows each partner to weigh their unique personal tax situation and come to their own conclusion.

Individual taxpayers, including partners in a partnership, must file Form 982 to defer debt income write-off processing and elect to reduce their tax base to depreciable assets. Such an election must be made on a timely filed return, including the extension, and may only be revoked with the consent of the IRS.

For real estate investors who have restructured some real estate debt due to the COVID-19 pandemic, the ability to defer debt income write-off could be an excellent tax planning opportunity, allowing them to avoid immediate taxable income. and cash payments from the IRS.

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