No-sweat workouts: avoiding taxes on commercial loan restructuring.

• Author: Briskin, Robert A.
• Position: Businesstax

Clients with commercial real estate financial problems may need loan workouts with their lenders to reduce their debt. Along with the financial and legal issues surrounding loan restructuring, your clients may face additional taxes.

In a loan workout, a debtor can realize cancellation of indebtedness income (COD income if new debt is issued to the property owner in exchange for the cancellation of the property owner's old debt or if there is a "significant modification" of the existing promissory note. Lenders report to the IRS a property's foreclosure or abandonment on Form 1099A, and certain lenders are required to report to the IRS a borrower's COD income on Form 1099C.

Single-family residential foreclosures and debt relief are governed by special tax rules beyond the scope of this article see "Tax Aspects of Foreclosures and 'Short Sales'." January/February 2009 California CPA).

Under the recently enacted American Recovery and Reinvestment Tax Act of 2009, clients can elect to defer recognizing COD income in connection with debt instruments used in the conduct of a trade or business [IRC Sec. 108(i)].

This tax rule would apply to real estate debt issued in the conduct of a trade or business, which is forgiven or modified (and treated as an exchange of debt instruments), between Dec. 31, 2008, and Jan. 1, 2011.

The COD income deferred is then included in the client's gross income ratably over a five-year period beginning in 2014. However, there is a provision to accelerate the COD income if the taxpayer dies, ceases business or sells substantially all of its assets. Thus, this new rule may be of limited help in the real estate context.

Recourse or Nonrecourse

When your client's real estate is foreclosed upon or a deed is given to the lender in lieu of foreclosure, the tax consequences of whether your client will be taxed as a "sale" of the real estate or realize COD income depends or nonrecourse.

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COD income-is taxable to a property owner as ordinary income under IRC Sec. 61(a)(12), bin the property owner/borrower nun be able to exclude that COD income under IRC Sec. 108 or defer recognizing ii under IRC Sec. 108(i). However, COD income is not realized for that portion of the foreclosure classified for tax purposes as a "sale" of the real property.

Recurse Promissory. Vote; When the lender forecloses on real estate secured by a recourse promissory note, the foreclosure is taxed to the client/borrower in two portions:

* The "sale" portion: client realizes taxable gain equal to the fair market value of the foreclosed real estate less client's tax basis in that real estate.

* The COD portion: the amount of indebtedness that exceeds the fair market value of the real estate. This portion may carry tax advantages since it can be excluded from your client's income.

Nonrecourse Promissory Note: Foreclosure of real estate secured by a nonrecourse promissory note means that the lender cannot obtain a judgment against your client for that loan's deficiency amount. Thus, there is no COD income. Instead, upon foreclosure--or if a deed is given to the lender in lieu of foreclosure--your client realizes...