Tax Strategies to Manage Distressed Real Estate Outcomes

Introduction

The real estate market is no stranger to cycles of boom and bust. In recent times, economic factors such as high inflation, rising interest rates, increasing vacancy rates, and slowing rental growth have converged to create a challenging environment for property owners. These conditions have led to an uptick in distressed properties, leaving many real estate owners grappling with tough decisions about managing their investments.

For owners facing these challenges, understanding the tax implications of various strategies to manage distressed real estate outcomes is crucial. Effective tax planning not only mitigates potential financial losses but also helps navigate the complexities of distressed property situations with greater confidence.

Understanding Distressed Real Estate Situations

Economic Factors Contributing to Distress

The current economic landscape has placed significant strain on the real estate sector. High inflation erodes purchasing power and reduces the real returns on investments. Rising interest rates increase the cost of borrowing, making debt servicing more expensive for property owners. Additionally, growing vacancy rates lead to reduced rental income, while slower rental growth impacts future cash flow projections. These factors collectively contribute to the financial distress experienced by many real estate owners today.

The Role of Debt in Real Estate Ownership

Debt financing is a common strategy in real estate acquisitions, offering leverage that can amplify returns in favorable markets. However, it also introduces debt covenants, restrictions, and service requirements that become burdensome when market conditions deteriorate. As cash flows tighten, property owners may find it increasingly difficult to meet their debt obligations, setting the stage for potential default or the need for debt restructuring.

Challenges Faced by Real Estate Owners

In the face of these economic pressures, real estate owners encounter several challenges:

• Debt Servicing Difficulties: Reduced rental income and increased expenses make it hard to meet regular debt payments.
• Declining Property Values: Market downturns can lead to property values falling below the remaining debt balances, undermining equity positions.
• Strategic Decisions: Owners must decide whether to retain properties and negotiate with lenders or consider disposing of assets to mitigate losses.

Potential Debt Outcomes for Distressed Real Estate Owners

When faced with financial distress, property owners have several avenues to explore with their lenders. Each option carries its own set of implications, both financially and tax-wise.

1. Principal Reduction: Negotiating with lenders to reduce the principal balance owed on the debt.
2. Debt Settlement: Settling the outstanding debt at a discount, typically less than the amount owed.
3. Debt Workout: Modifying the terms of the debt, such as extending maturities or altering interest rates, to make payments more manageable.
4. Fire Sale: Selling the property quickly, often at a reduced price, to satisfy the debt obligations.
5. Deed-in-Lieu of Foreclosure: Voluntarily transferring property ownership to the lender to avoid foreclosure proceedings.
6. Foreclosure: The lender legally repossesses the property due to the owner’s failure to meet debt obligations.

The first three scenarios allow the owner to retain the property, providing opportunities to recover value over time. The latter three result in the loss of the asset and may involve additional financial repercussions, including potential tax liabilities that can exacerbate the owner’s financial strain.

Tax Implications of Distressed Real Estate Outcomes

Navigating the tax landscape is essential when dealing with distressed real estate. Each potential outcome affects the owner’s tax situation differently, depending on factors such as the type of debt (recourse or nonrecourse), the fair market value of the property, and the owner’s tax basis in the property. Understanding these implications can inform better decision-making and strategy development.

Scenario 1: Property is Retained

Lender Reduces Principal Balance or Settles Debt at a Discount

When a lender agrees to reduce the principal balance or settle the debt for less than the amount owed, the borrower may experience what the Internal Revenue Service (IRS) considers “discharge of indebtedness income” (also known as cancellation of debt income). This forgiven debt is typically includable in the borrower’s taxable income, potentially leading to an unexpected tax liability.

Tax Implications for Solvent Taxpayers

For taxpayers who are solvent (their assets exceed their liabilities), the discharge of indebtedness income is generally recognized as ordinary income. However, there is a provision that may offer relief: the exclusion for Qualified Real Property Business Indebtedness (QRPBI). Under this exclusion, taxpayers may be able to exclude some or all of the discharged debt from their taxable income, subject to specific limitations:

• Limit Based on Fair Market Value: The exclusion cannot exceed the difference between the outstanding debt immediately before the discharge and the fair market value (FMV) of the property securing the debt. This ensures that taxpayers do not create tax-free equity.
• Basis Reduction Limitation: The amount excluded cannot exceed the aggregate adjusted bases of depreciable real property held immediately before the discharge, after accounting for any depreciation taken in the year of discharge and any prior basis reductions.

It’s important to note that while the exclusion can mitigate immediate tax liability, it requires a corresponding reduction in the basis of the depreciable real property, potentially affecting future depreciation deductions and gain or loss calculations upon sale.

Tax Implications for Insolvent Taxpayers

For taxpayers who are insolvent (their liabilities exceed their assets), the tax treatment differs:

• Exclusion Up to Insolvency Amount: Insolvent taxpayers can exclude discharge of indebtedness income to the extent of their insolvency. For example, if a taxpayer is insolvent by $100,000 and has $150,000 of discharged debt, they can exclude $100,000 from income.
• Bankruptcy Exception: If the debt is discharged in a Title 11 bankruptcy case, the entire amount can be excluded from income. However, similar to the insolvency exclusion, tax attributes must be reduced accordingly, deferring but not eliminating tax consequences.

These exclusions require careful calculation and documentation of the taxpayer’s financial position immediately before the debt discharge.

Special Considerations for Partnerships

In the context of partnerships owning real estate, tax implications can become more complex:

• Determination at Partnership Level: Whether the debt qualifies as QRPBI and the calculation of limitations are determined at the partnership level.
• Exclusion at Partner Level: Individual partners make the election to apply the exclusion on their personal tax returns, and the exclusion applies at the partner level.
• Basis Reduction: Each partner’s share of the partnership’s basis in depreciable real property is reduced according to their proportionate interest, affecting future tax calculations.

Partners must coordinate with the partnership and potentially other partners to ensure accurate tax reporting and optimal outcomes.

Special Rule for Purchase Money Mortgages

A purchase money mortgage occurs when the seller of a property also finances the buyer’s purchase. In situations where the seller-lender reduces the principal balance:

• Purchase Price Adjustment: The debt reduction may be treated as a reduction in the property’s purchase price rather than discharge of indebtedness income, avoiding immediate taxable income.
• Limitations: This treatment generally applies when the borrower is solvent and not in bankruptcy. It is also applied at the partnership level for properties held in partnerships.

This special rule recognizes the nature of the original transaction and provides relief by adjusting the basis rather than creating taxable income.

Lender and Borrower Agree to a Debt Workout

Modifying the terms of existing debt can offer relief but may also trigger tax consequences under certain conditions.

Significant Debt Modifications and Deemed Exchanges

If the modifications to the debt are considered “significant,” the IRS treats the transaction as an exchange of the existing debt for a new debt instrument. Key points include:

• Issue Price Determination: The new debt’s issue price is considered as the amount used to satisfy the old debt.
• Discharge of Indebtedness Income: If the new debt’s issue price is less than the adjusted issue price of the old debt, the borrower recognizes discharge of indebtedness income for the difference.

A significant modification can include changes to yield, maturity, collateral, or other terms that substantially alter the original agreement.

Requirements and Exceptions

Not all modifications result in a deemed exchange. Key considerations are:

• Modification Definition: Any alteration of legal rights or obligations, including changes in payment schedules, interest rates, or covenants.
• Significance Threshold: The modification must be significant, meaning it results in a change in the economic position of the parties.
• Non-Significant Modifications: Changes that are considered minor, such as temporary forbearance (up to two years) or adjustments to financial covenants, typically do not trigger a deemed exchange.

Understanding these nuances is vital to avoid unintended tax consequences when restructuring debt.

Scenario 2: Property is Disposed Of

Owner Sells Property or Lender Forecloses and Forces a Sale

When a property is sold or foreclosed upon, the transaction is treated as a sale for tax purposes, and the owner must calculate any resulting gain or loss.

Tax Treatment of Sale Transactions

The gain or loss is determined by subtracting the property’s adjusted tax basis from the amount realized on the sale. Key considerations include:

• Amount Realized: Includes cash received, the fair market value of any property received, and relief from the debt obligations.
• Nonrecourse Debt: The full amount of the debt is included in the amount realized, regardless of the property’s fair market value.
• Recourse Debt: If the debt exceeds the property’s fair market value, the transaction is bifurcated:
  • Sale Component: The fair market value of the property is used to calculate gain or loss.
  • Discharge of Indebtedness Income: Any remaining debt forgiven is treated as ordinary income, subject to insolvency and bankruptcy exclusions.

This distinction between recourse and nonrecourse debt significantly affects the tax outcome and must be carefully analyzed.

Owner Transfers Property to Lender in Satisfaction of Debt (Deed-in-Lieu)

A deed-in-lieu of foreclosure allows the owner to transfer the property to the lender voluntarily, avoiding formal foreclosure proceedings. Tax implications are similar to a sale:

Tax Treatment for Nonrecourse and Recourse Debt

• Amount Realized with Nonrecourse Debt: The entire outstanding debt is considered the amount realized, potentially leading to a gain if it exceeds the adjusted basis.
• Recourse Debt Exceeding FMV: The transaction is split:
  • Gain or Loss on Property Transfer: Calculated using the property’s fair market value.
  • Discharge of Indebtedness Income: Any forgiven debt above the property’s FMV is taxable as ordinary income, with possible exclusions.

This approach ensures that the owner recognizes income or loss appropriately, reflecting both the disposition of the property and the forgiveness of debt.

Other Tax Considerations for Deemed Sale Transactions

Disposing of property in these circumstances may trigger additional tax consequences:

• Depreciation Recapture: Portions of the gain attributable to prior depreciation deductions may be taxed as ordinary income under Section 1245 or at a higher capital gains rate under unrecaptured Section 1250 gain rules.
• Tax Attribute Reduction: When exclusions apply, future tax benefits, such as net operating losses or credit carryforwards, may be reduced.

These factors can significantly impact the overall tax liability and should be included in any comprehensive tax planning strategy.

Strategies to Mitigate Tax Liabilities in Distressed Situations

While distressed real estate scenarios are challenging, proactive planning can help manage and potentially reduce tax liabilities.

Utilizing Exclusions and Deferrals

Taxpayers may leverage certain provisions to exclude or defer recognizing discharge of indebtedness income:

• QRPBI Exclusion: Electing to exclude income related to qualified real property business indebtedness, subject to limitations, with a corresponding basis reduction.
• Insolvency Exclusion: Excluding income to the extent of insolvency, requiring careful calculation of assets and liabilities.
• Bankruptcy Exclusion: Discharged debts in bankruptcy can be excluded, but future tax attributes may be reduced.

These provisions can provide significant relief but often involve trade-offs that impact future tax positions.

Planning for Debt Restructuring

When negotiating debt modifications:

• Avoid Significant Modifications: Structuring changes to avoid triggering a deemed exchange can prevent immediate tax consequences.
• Understand Tax Effects: Evaluating the tax implications before finalizing agreements ensures that the economic benefits are not offset by unexpected tax liabilities.

Working closely with tax professionals during negotiations can help achieve favorable terms while minimizing adverse tax outcomes.

Managing Recourse vs. Nonrecourse Debt

The nature of the debt affects tax treatment:

• Identifying Debt Types: Understanding whether debt is recourse or nonrecourse under tax law, which may differ from legal classifications.
• Exploring Conversion Options: In some cases, restructuring debt to change its nature may be beneficial, though this requires careful consideration and lender cooperation.

This strategy must be approached cautiously, as changes can have complex legal and tax ramifications.

Partnership Considerations

For partnerships, additional layers of complexity exist:

• Coordinated Planning: Aligning strategies among partners to optimize overall tax outcomes and address individual partners’ tax situations.
• Impact on Basis and Capital Accounts: Debt modifications and exclusions affect partners’ bases and capital accounts, influencing future distributions and allocations.

Effective communication and collaboration among partners and advisors are essential to navigate these challenges successfully.

Best Practices for Real Estate Owners Facing Distressed Situations

Adopting proactive measures can help real estate owners manage distress more effectively and reduce negative financial impacts.

Early Engagement with Lenders

Open and honest communication with lenders can lead to mutually beneficial solutions:

• Exploring Workout Options: Lenders may be willing to modify terms to avoid default, preserving value for both parties.
• Negotiating Favorable Terms: Understanding the lender’s priorities can help in crafting agreements that minimize tax consequences.

Early engagement demonstrates a commitment to resolving issues and can provide more options for relief.

Assessing Financial Health and Solvency

Accurate assessment of the owner’s financial position is crucial:

• Determining Solvency Status: Essential for applying insolvency exclusions and understanding potential tax liabilities.
• Considering Bankruptcy Implications: Evaluating whether bankruptcy proceedings offer a strategic advantage in managing debts and taxes.

Regular financial reviews enable informed decision-making and timely action.

Consulting with Tax Professionals

Expert guidance is invaluable in navigating the complex tax landscape:

• Interpreting Tax Regulations: Professionals stay updated on laws and regulations, ensuring compliance and optimal strategies.
• Tailoring Strategies: Customized advice aligns with the owner’s specific circumstances, goals, and risk tolerance.

Engaging advisors early in the process maximizes the benefits of their expertise.

Planning Ahead

Proactive planning can mitigate future distress:

• Maintaining Detailed Records: Accurate documentation of property basis, adjustments, and financial transactions supports effective tax planning.
• Monitoring Market Trends: Staying informed about economic indicators and real estate markets aids in anticipating challenges.
• Understanding Long-Term Impacts: Evaluating how current decisions affect future tax positions and financial health.

Forward-thinking strategies position owners to respond more effectively to changing conditions.

Conclusion

Distressed real estate situations present complex challenges that extend beyond immediate financial concerns to significant tax implications. By understanding the tax consequences of various debt outcomes and employing strategic planning, real estate owners can mitigate potential liabilities and navigate these difficulties with greater confidence.

Key strategies include leveraging available tax exclusions, carefully planning debt restructurings, managing the nature of debt, and collaborating with partners and professionals. Proactive engagement with lenders and advisors, combined with diligent financial management, can make a substantial difference in outcomes.

In these uncertain times, informed decision-making supported by expert guidance is essential. By taking deliberate steps, real estate owners can better manage distressed situations and position themselves for future success.

Additional Resources

For personalized assistance and further guidance on managing the tax implications of distressed real estate, consider reaching out to experienced professionals who specialize in this area.

At GreerWalker, our team of seasoned advisors is equipped to help you navigate these complex scenarios. We offer tailored strategies designed to align with your specific needs and financial goals. Connect with us to discuss your situation and explore how we can support you in managing distressed real estate outcomes effectively.

About the Authors

Stacia Neugent is a partner in the firm’s tax practice. Since joining GreerWalker, she has focused her efforts primarily on serving clients in the real estate industry. She has significant experience serving clients with complex capital structures and complicated economic waterfalls/tax allocations.

Scott Doxey is a director in our tax practice. He has over eight years of experience in the corporate, partnership and individual taxation areas. His industry focus includes real estate as well as professional services industries. In addition, he serves clients in the manufacturing and distribution industry.