As If Distressed Commercial Property Foreclosure Isn’t Stressful Enough, Don’t Forget Taxes

Commercial property is facing rising vacancy rates paired with rising interest rates. What happens when commercial property becomes distressed because the property owners either are not generating rents to sustain cash flow to pay the mortgage or the value of the property has fallen below the outstanding debt, making lenders unwilling to extend, refinance, or renew loans?

Either situation is a recipe for foreclosure, in which property is sold to satisfy the outstanding debt or deeds in lieu of foreclosure, transferring the property to the lender in satisfaction of the debt. These transactions may have significant tax consequences that catch many property owners off guard. Depending on the type of debt, there may be steps borrowers and lenders can take to make the tax consequences less painful.

Types of Debt: Recourse and Nonrecourse Debt

A debtor’s tax consequences in a foreclosure or deed in lieu of foreclosure situation generally depend on the type of debt and the debtor’s adjusted basis in the encumbered real property.

Recourse debt allows the lender to foreclose on the property and thereafter pursue the debtor for the remainder of the outstanding debt. The borrower is personally liable for the entire amount of the debt. Nonrecourse debt, by contrast, is secured by the real property only, leaving the lender with no means to recover any remaining debt balance.

Recourse Debt

Satisfaction of recourse debt by foreclosure or a deed in lieu of foreclosure is generally treated as a deemed sale for federal income tax purposes, with the deemed sale’s proceeds valued at equal to the lesser of the fair market value (“FMV”) of the property at the time of foreclosure or the amount of the secured debt.

As noted above, the borrower is personally liable for recourse debt and a lender can pursue the borrower for the remainder of the debt after foreclosure or deed in lieu of foreclosure. If any of the recourse debt is forgiven, the borrower generally incurs cancellation of debt (COD) income for the amount forgiven, which is generally included in the borrower’s gross income and taxed as ordinary income (these possible income tax results may vary depending on whether the debtor is insolvent for federal income tax purposes). If the property’s FMV exceeds the amount of the debt, there is no COD income. The borrower generally does not incur COD income if the lender pursues the borrower for the deficiency and the borrower pays the deficiency.

Recourse debt transactions are often treated in a bifurcated manner. For example, the debtor could have COD income if the debt exceeds the property’s FMV. The debtor could also have a gain or loss from the deemed sale of the property calculated as the difference between the FMV and the adjusted tax basis in the property. The amount realized is generally the total canceled debt less the COD income. Unpaid interest is added to principal, and discharged accrued interest that the borrower previously deducted for federal income tax purposes is included in gross income.

Nonrecourse Debt

When a lender forecloses or there is a deed in lieu of foreclosure on a property in satisfaction of a nonrecourse debt it is generally treated as a deemed sale for federal income tax purposes. The proceeds of the deemed sale equal the amount of the nonrecourse debt. Thus, there is generally no COD income in a foreclosure or deed in lieu of transaction involving only nonrecourse debt.

The gain or loss from this deemed sale is the difference between the amount of the outstanding nonrecourse debt plus any additions to principal that generated ordinary deductions for the debtor and the adjusted basis in the property. The amount realized is the outstanding principal amount even if the FMV is lower than the outstanding nonrecourse principal balance. A property’s FMV does not factor into nonrecourse debt foreclosures.

Income Tax Differences between Recourse Debt and Nonrecourse Debt

In recourse debt foreclosures, proper planning may limit ordinary income exposure and possibly maximizing income classified as capital gain. Weaver is committed to guiding our clients through these difficult transactions that affect debtors and lenders alike. We are here to help. Contact us for information or assistance.

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