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Tax Strategies for Commercial Real Estate Debt Discharge

It is no surprise that the commercial real estate industry has been dramatically impacted by the COVID-19 pandemic. Tenants are strapped for cash and employees are working from home, leaving building owners impacted twofold. Property-owners find themselves working with tenants on rent deferrals or abatements, early lease terminations, or modifications, to reduce existing space. The result is a devaluation of commercial real estate, leaving companies overleveraged and unable to pay their debt. While survival is the first thing on any company’s mind, there are ways to structure debt workouts to reduce massive tax liabilities from cancellation of debt (COD).

For Corporations, including S-Corporations, COD income can be excluded from gross income for federal income tax purposes under Section 108(a)(1)(A) if the debt is discharged in bankruptcy under chapter 11. In addition, corporations that are merely insolvent immediately before a discharge – having liabilities in excess of the fair market value of assets – can exclude COD income to the extent of their insolvency under Section 108(a)(1)(B). As it relates to partnerships, the bankruptcy and insolvency analysis is performed at the partner level, therefore those are much harder to achieve. 

Taxpayers that choose to exclude COD, as a result of bankruptcy or insolvency, are required to reduce tax attributes. Unless the taxpayer elects otherwise, the tax attributes are required to be reduced by the amount of debt discharged in the following order: 

  • Net operating losses
  • General business credits
  • Minimum tax credits
  • Capital loss carryforwards
  • Basis reduction of property
  • Passive activity losses and credit carryovers
  • Foreign tax credit carryovers

Taxpayers, other than C-Corporations, have an opportunity to exclude COD income generated from Qualified Real Property Business Indebtedness. This exception only applies to debt incurred in connection with and secured by real property used in a trade or business. In the case of partnerships, disregarded entities and grantor trusts, the income exclusion and election are reported at the partner level. Conversely, the determination of whether the indebtedness is Qualified Real Property Business Indebtedness is determined at the partnership level.

The following criteria must be met to be considered Qualified Real Property Business Indebtedness:

  • The real property must be held by the partnership in connection with a trade or business conducted by the partnership. A rental arrangement under a triple net lease may not qualify as a trade or business;
  • The indebtedness was incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property; and
  • The partner must make a timely election on their personal income tax return.

The amount of COD from Qualified Real Property Business Indebtedness is determined at the partnership level and is limited to the excess of the outstanding principal amount of the indebtedness, immediately prior to the discharge over the fair market value of the real property, reduced by the outstanding principal amount of any other Qualified Real Property Business Indebtedness secured by such property. Once the amount is determined, the election is made by filing Form 982, which reduces the basis of the partner’s interest in the partnership by the amount of COD income excluded.

There are several strategies to restructure, modify, or eliminate liabilities, which can reduce the adverse federal income tax consequences of COD income that are dependent on individual facts and circumstances. We are here to work with you to find the best approach for you and your business. Please contact your Citrin Cooperman professional today to find out more.

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