In tough economic times, real estate owners and investors often work with their lenders to restructure mortgage debt. Lenders may be willing to reduce the interest rate, extend the repayment term or even forgive a portion of the debt. These modifications can provide welcome financial relief, but it is important to understand the tax implications. Any time a lender reduces your principal balance, lowers your interest payments or gives you more time to pay, you may have cancellation of debt (COD) income, which is reportable as ordinary income on your tax return.
Not every modification of a mortgage loan triggers COD income, however. There are a number of exceptions and exclusions that may allow you to avoid or defer COD income. For purposes of this discussion, several exclusions may be relevant:
- Debts discharged in bankruptcy;
- Debts canceled when the taxpayer is insolvent. COD income is excluded only to the extent of your insolvency — that is, the amount by which your liabilities exceed the fair market value of your assets (Note: For partnerships, COD income is passed through to the individual partners, so whether the insolvency exclusion applies depends on each partner’s financial situation);
- Cancellation of qualified real property business indebtedness (see below); and
- Cancellation of qualified principal residence indebtedness (see below).
Qualified Real Property Business Indebtedness
You may elect to exclude COD income (subject to certain limits) for debt that is incurred or assumed in connection with, and secured by, real estate used in a trade or business. In addition, debt incurred or assumed after 1992 must be used to acquire, construct, or substantially improve the property. Real estate used in a trade or business generally includes rental real estate, but not real estate held for sale (Note: For some real estate — such as properties subject to a triple-net-lease — it may be difficult to ascertain whether they are used in a trade or business or are ineligible investment properties.) A separate exclusion is available for qualified farm indebtedness.
Qualified Principal Residence Indebtedness
Through the end of 2025, homeowners may exclude up to $750,000 in COD income ($375,000 for married couples filing separately) in connection with a mortgage used to buy, build or substantially improve their principal residence. The debt must be secured by the residence. This exclusion also applies to debt used to refinance such a mortgage, up to the amount of the original mortgage principal immediately before the refinancing.
Requirement to Reduce Tax Attributes
Generally, the exclusions discussed above allow you to defer the tax rather than avoid it permanently. When you exclude COD income, you are required to reduce certain tax attributes (but not below zero), potentially increasing your tax liability in future years. For example, if you exclude COD income related to qualified real property business indebtedness, you must reduce the tax basis of depreciable property by the amount excluded. Similarly, if you exclude COD income related to qualified principal residence indebtedness, and you continue to live in the home, you must reduce its basis. If you take advantage of the bankruptcy or insolvency exclusions, you’ll need to reduce one or more tax attributes, such as net operating losses, certain tax credits, capital loss carryovers, or the basis of certain properties.
The rules regarding application of the various exclusions and reduction of tax attributes are quite complex, particularly for real estate owned by partnerships. If you have restructured mortgage debt or plan to in the near future, please contact us to discuss your tax-planning options.
For more information, please contact Jeff Newman at [email protected] or 312.670.7444.. Visit ORBA.com to learn more about our Real Estate Group.