In the past few years, the real estate industry has endured difficult times and given the climate, real estate investors have often been faced with owning properties whose fair market value (FMV) is less than the debt outstanding on the property. The loans on many of these properties can be delinquent as the borrower is unable to generate the necessary cash flow from the property to service the debt leading to their lender potentially settling the debt with foreclosure. Foreclosures tend to be costly causing lenders and borrowers to look for alternative options to settle the debt.
One alternative to foreclosure that both lender and borrower may consider is to negotiate a settlement in which the borrower voluntarily relinquishes title to the property to the lender and the lender agrees to stop the foreclosure. This is known as a “deed in lieu of foreclosure”. These types of transactions can be accompanied by complex tax ramifications. One key component in determining how these transactions will be taxed depends on whether the loan is recourse or non-recourse.
DEED IN LIEU OF FORECLOSURE INVOLVING RECOURSE DEBT
Recourse debt is a loan where the borrower is personally liable for repayment. When recourse debt is involved in a deed in lieu of foreclosure, the transaction typically results in cancellation of debt (COD) income. The transfer of property is treated as a deemed sale with “proceeds” being equal to the property’s FMV. The transaction is referred to as a “bifurcation” because two taxable transactions result from one economic event:
- If the debt exceeds the property’s FMV, the excess is treated as COD income taxable as ordinary income unless an exclusion applies (see below).
- If the FMV is greater than the adjusted basis of the property the taxpayer may recognize a capital gain. Conversely, if the FMV is less than the adjusted basis of the property, the taxpayer recognizes a loss. This can lead to a taxpayer recognizing a gain or loss on the disposition while also recognizing COD income when the debt is greater than the FMV of the property.
FORECLOSURE INVOLVING NON-RECOURSE DEBT
Nonrecourse debt is a loan that is secured solely by one or more assets and where the borrower is not personally liable. If the debt is considered non-recourse debt, the transaction is also treated as a deemed sale, but the “proceeds” are equal to the outstanding debt balance (as opposed to the FMV of the property). Therefore, there is typically no COD income from a deed in lieu of foreclosure transaction involving non-recourse debt. Instead, the debtor may realize a capital gain measured by the difference between the outstanding debt balance and the adjusted basis of the property. Consequently, deeds in lieu of foreclosure transactions involving non-recourse debt can provide a more favorable Federal tax result since the transaction often results in a capital gain transaction rather than COD which is taxed at ordinary tax rates.
EXCLUDING CANCELLATION OF DEBT (COD) INCOME FROM GROSS INCOME
Cancellation (or forgiveness) of debt results in taxable income to the debtor unless an exception applies. One of the most common exceptions for real estate investors applies to “qualified real property business” debt.
A taxpayer, other than a C Corporation, who is not insolvent or bankrupt, can elect to exclude COD income arising from the discharge of qualified real property business debt. The election allows for a taxpayer to reduce their basis in the real property rather than recognize the COD income. When the COD income exceeds the taxpayer’s basis in the property the excess remains taxable as COD. Qualified real property business debt includes debt incurred in connection with real property used in a trade or business and secured by such real property. Examples of qualifying trades or businesses include rental properties, land and improvements used in a trade or business such as a golf course and properties owned by the taxpayer from which their business is operated.
Other common exceptions allowing for the exclusion of COD income include bankruptcy, insolvency and qualified principal residence indebtedness.