I have heard that borrowers have to pay taxes on the debt forgiven in a foreclosure or debt restructure.
- Is that true?
- Where do I find it on the tax return?
- Should I count it in cashflow calculations?
In some cases the borrower will pay taxes on the debt forgiven. The IRS treats it like a sale. There are variations as to whether the borrower has to pay, how the ‘income’ is treated (capital gain or ordinary income) and where you will find it.
A general understanding of borrower options will help you estimate the real impact of a restructure or foreclosure both on cashflow and the borrower’s ability to pay the newly restructured debt.
This is a very complicated area, so feel free to stop after these first bullet points or dig deeper. Here is the bottom line first…
- You will find capital gains/losses from a restructure or foreclosure on Schedule D or Form 4797 as usual. Generally you will not count this as recurring cashflow.
- You will find the Cancellation of Debt (COD also called ‘Forgiveness of Debt’) income on the ‘other income‘ line of the tax return filed by the borrower, Line 21 on a 1040.
- COD income is noncash and nonrecurring and should not be counted in recurring cashflow.
- The tax consequences to foreclosure, liquidation and restructure of debt are complicated and there are several legitimate ways to reduce or defer the related taxes.
- Your borrower should work with their CPA or Tax Attorney to understand the tax ramifications of these options.
It is completely okay to stop reading here…or if you prefer:
- Basis of property: The original cost of the property plus the cost of major improvements.
- Cancellation of Debt (COD) income: the difference, in a foreclosure, between the discharged debt and the Fair Market Value of the Property.
- Capital gains: A profit made from buying something (property, shares of stock, etc) and reselling it at a higher price.Capital gains on property held one year or more receive better tax treatment than ordinary income.
- Fair Market Value: The price that property would sell for on the open market. It is the
price that would be agreed on between a willing buyer and a willing
seller, with neither being required to act, and both having reasonable
knowledge of the relevant facts.
- Foreclosure: The legal proceedings initiated by a creditor to repossess the collateral for a loan that is in default.
- Nonrecourse debt: The lender’s only recourse upon the borrower’s default on the debt is against the property securing the debt.
- Recourse debt: The lender can look beyond the collateral pledged for the loan and hold the borrower–or a pass-through entity like an LLC, its owners–personally accountable for the unpaid balance.
This information is used in the nonrecourse and recourse examples below:
$12 Million | Basis of Property
$15 Million | FMV
$19 Million | Debt Discharged
Nonrecourse: A foreclosure by a nonrecourse note holder is treated as a sale by the owner to the creditor for the outstanding balance of the debt (or FMV if higher). The owner recognizes gain or loss equal to the difference between the tax basis of the property transferred and the amount of the debt discharged (or FMV if higher).
This can result in a capital gain if the borrower is ‘upside down’ and the discharged debt is higher than the basis in the property. How did that happen? Typically there has been a refinance along the way based on increased fair market value that has now evaporated.
The foreclosure of a nonrecourse debt can also result in a capital loss if the debt discharged is less than the basis. In both cases, the capital gain or loss will be reported on a Schedule D or if a business asset, Form 4797.
In this example, with foreclosure of a nonrecourse debt, the borrower would show $7 Million in capital gains. (See later in article for options to pay later.)
Recourse: If the foreclosure is by a recourse note holder, the result can be a combination of capital gain/loss and ordinary income. In this case, there are three relevant amounts.
- Basis of the property
- Fair Market Value (amount it sells for at foreclosure)
- Amount of indebtedness
Capital gain/loss is based on the difference between the fair market value and the tax basis of the property. Note this can be a gain or a loss. This will be reported on Schedule D or Form 4797.
In addition, if the indebtedness exceeds the fair market value, the difference would be Cancellation of Debt (COD) Income and will be reported as ordinary income to the extent forgiven by the lender, typically on an ‘other income’ line of the relevant return.
$ 3 Million ~ Capital Gain
$ 4 Million ~ COD (Ordinary) Income
$ 7 Million ~ Total Taxable Gain
Often a debt restructure is either principal deferral (interest only payments for an agreed period of time) or a lengthening of the term of the loan to reduce payments. Neither of those have an impact on taxes. But if the lender allows either payoff or sale to a related party of less than the debt amount in full payment of that debt, the transaction will trigger recognition of COD income.
It does not matter if the borrower pays cash to discharge the debt, takes on a new debt to replace the old debt or significantly modifies the debt.
Also, in a restructure, the COD income will be triggered whether the loan was recourse or nonrecourse. A negotiated restructure will result in income to the borrower who owes the funds. (This could be an individual, an LLC or other entity.)
Pay now, pay later or don’t pay…
Prior to the American Recovery and Reinvestment Act of 2009 (ARRA) there were provisions in tax law that in some cases allowed for a reduction in basis of the underlying property instead of recognizing taxable income as a result of a restructure. When this approach was used, there would be no indication in the tax return itself that a restructure had occured.
The borrower essentially pays later because with a lowered basis, the gain on the ultimate sale of the property will be higher.
The new law allows another way to pay later, an election to defer COD income recognized from the ‘reacquisition’ of an ‘applicatble debt instrument’ that occurs in 2009 or 2010. If this provision applies, the borrower can pay no taxes on the COD income until 2014 and then spread the tax due over five years. All the tax will become due if the taxpayer dies, liquidates or sells substantially all of its assets, ceases to do business or something similar.
How about ‘don’t pay‘? If the borrower’s tax situation is such that any gain or income will be offset by other losses this year (including a net operating loss rolling forward), and they anticipate being in much better shape (translate will pay more taxes) later, they may choose to take the gain or recognize the income this year.
It is complicated…
The impact of a foreclosure, bankruptcy or restructure on a borrower is complicated so be very careful not to give advice. Here is the recap…
- Your borrower should work with their CPA or tax attorney to understand the tax ramifications of these options.
- There are tax consequences to foreclosure, liquidation and restructure of debt and several legitimate ways to legitimately reduce or defer the taxes triggered by a foreclosure or restructure.
- The opportunity to defer taxes on the COD income is only one option the tax adviser will consider, and may not be the best option for the borrower.
- Capital gains and/or COD income from loan restructure or liquidation is unlikely to impact recurring cashflow unless the borrower has deferred taxes on a significant amount. In that case, the impact may not hit until 2014.
Digging even deeper
Most lenders should stop reading right here. If you are still reading, you are either a glutton for punishment or deeply involved in restructures for more complicated borrowers.
For most lenders, knowing to watch for COD income and subtract it as both noncash and nonrecurring is key. And understanding there are significant tax consequences, legitimate ways to mitigate them, and the advice of a CPA or tax attorney is important for your borrower may be all you need.
But if you want the independent ability to assess the borrowers options, here are two articles that will take it deeper:
Tax Consequences of Mortgage Discharge
Journal of Accountancy
Authors: Michael M. Smith (firstname.lastname@example.org) is a shareholder, and Michael Evans (email@example.com) is an attorney, both at Baker Donelson Bearman Caldwell & Berkowitz PC in Atlanta. Donald L. Ariail (firstname.lastname@example.org)
is an associate professor in the Department of Business Administration
at Southern Polytechnic State University in Marietta, Ga.
New Tax Laws Impact COD Income
Article by Foley & Lardner LLP
Foley is a national law firm with a practice that encompass the full range of corporate legal services. Contact: Peter J. Elias (email@example.com), Van A. Tengberg (firstname.lastname@example.org), Adam B. O’Farrell (email@example.com)