Tax planning for troubled debt.

• Author: Dillon, Paul

Today's volatile real estate environment presents interesting opportunities for investors and developers to alter the terms of their debts in ways that may pay off if they can retain control of their projects. The downside to doing so, though, is that they may recognize cancellation of debt (COD) income. At the same time, other developers will be facing foreclosure and phantom income from debt relief. With foreclosures and significant loan modifications the order of the day, real estate owners, investors, and their tax advisers need to be aware of the COD rules and plan carefully for the tax implications of these transactions.

The American Recovery and Reinvestment Act, P.L. 111-5, allows certain taxpayers who realize income from COD in 2009 or 2010 to defer that income and recognize it ratably over five years, beginning in 2014 (See. 108(i)). For taxpayers electing to defer COD income under this new law, the other COD exclusions in the Code would not be available. However, already existing provisions may provide a much greater benefit.

This new provision defers the recognition of income for only a limited period of time. Other COD rules already existing in the Code may be more beneficial by providing for exclusion of COD income. Bankrupt or insolvent taxpayers may be able to escape recognition of COD income entirely, depending upon their specific circumstances. Qualified real property indebtedness may also be excluded, depending upon the taxpayer's circumstances.

The rules for COD income vary depending on whether the debt related to the property being foreclosed upon is subject to recourse debt, nonrecourse debt, or partially recourse and partially nonrecourse financing.

COD Income Rules for Recourse Debt

When a lender forecloses on property in satisfaction of a recourse debt, the foreclosure is deemed to be a sale, with the sales proceeds equal to the amount of the debt or the fair market value (FMV) of the property, whichever is less. The difference between the deemed sale proceeds and the property's cost basis equals the gain or loss on the sale. To the extent the debt exceeds the property's FMV, the taxpayer is deemed to have COD income. In other words, when the property has recourse financing, the transaction is bifurcated into two transactions, a sale transaction and a COD transaction.

Since a foreclosure is treated as a sale or exchange of property, the character of any gain or loss is determined in accordance with the provisions of Secs. 1221 and 1231. As a result, if the mortgagor had held the property as a capital asset under Sec. 1221 or for use in a trade or business under Sec. 1231, any gain is a capital gain or a Sec. 1231 gain. In the case of Sec. 1231 assets, the gain is also subject to the recapture rules in Sec. 1250. Alternatively, if the property was held primarily for sale to customers in...