Debtor Solutions Lie with Solvency
For the last few years, the only news you hear for real estate is bad news. Foreclosures and deeds in lieu of foreclosure still dominate the sales market and banks have become much more restrictive in their lending practices, Nevertheless, banks are becoming more willing to restructure troubled loans both for personal residences and for business property. Unfortunately, when mortgages are restructured, the debtor can end up with phantom taxable income from the cancellation of debt, resulting in a tax liability with no cash to pay the taxes. There are, however, exceptions to these rules.
If the debtor is solvent, for qualified business real estate, a restructuring that results in a reduction of the debt will normally result in immediate cancellation of debt income for the debtor unless the debtor makes an election to exclude cancellation of debt income which requires the reduction of the basis of depreciable real estate beginning in the year after the year of the election. The effect is to postpone the recognition of income rather than permanently exclude it.
If the debtor is in bankruptcy or is insolvent, a reduction in the mortgage does not create currently taxable discharge of debt income to the extent that the debtor is still insolvent after the reduction in the debt. The debtor is required to reduce tax attributes such as net operating loss carryovers, credits, capital loss carryovers, passive loss carryovers, and the basis of the property. Again, the effect is to postpone rather than permanently exclude the income.
The manner in which the property is held could have a dramatic effect on the operation of these rules. If the business real estate is held in an S Corporation, the rules operate at the entity level. In other words, solvency is determined at the corporation level and any reduction in basis (if solvent) or in other tax attributes (if insolvent) occur at the corporate level. Insolvency is much easier to determine and sustain at the entity level. For partnerships, solvency is determined at the individual partner level. For example, a partnership that holds real estate may itself be insolvent, but if any of the individual partners are solvent, the exclusion of income will not apply to any solvent partners and the insolvency exception won’t be allowed for those partners. If the solvent partners wish to avail themselves of the election to reduce basis, that election is made at the individual partner level rather than the entity level. In summary, the rules tend to be much more favorable for S corporations than for partnerships. In certain situations, it may be possible to convert from a partnership to an S corporation to avail yourself of the more favorable rules.
In either case, the rules are very detailed and complex and I urge you to seek the aid of an ORBA tax professional before you restructure your business real estate debt. We are here to help.