Commercial Real Estate Blog by Madison

Deferring Taxes when Debt is Forgiven, Part 3

While a §1031 like kind exchange is a great tool to defer capital gains taxes, there are other legitimate ways to defer or avoid taxes. For the last few weeks, we’ve examined Internal Revenue Code §108 for ways to do just that. Given market conditions, there is an opportunity to write off mortgage debt and to turn a losing investment into a winner. Internal Revenue Code §108 offers five kinds of debt forgiveness. Here we will examine the final point:  Deferring Taxes With Qualified Real Property Business Indebtedness.

A Case Study on Deferring Taxes after Forgiveness of Debt

To understand, we are using a case in point. Here are the key points. Frank owns an office building that he bought for $1,000,000. It has a $700,000 mortgage. Currently, it is only half occupied, and its current FMV is $500,000. The property has a negative cash flow. The bank would accept a $500,000 payoff of its $700,000 loan. Frank could payoff that loan by taking out a new mortgage in the amount of $350,000, and investing $150,000 of new cash. The building would then generate positive cash flow, and its value would appreciate sharply if Frank can improve the occupancy rate. The problem for Frank is that forgiveness of debt in this case would trigger $200,000 of technical income ($700,000 face value of the mortgage minus the $500,000 payoff) through forgiveness of debt, and Frank cannot afford to pay the taxes on money that he has not actually received.

IRC §108 on Forgiveness of Debt

We saw that Internal Revenue Code §108 describes five kinds of debt that can be forgiven without immediately recognizing income. They are:
A. Debt discharged in a Chapter 11 bankruptcy
B. Debt discharged when the debtor is insolvent
C. Qualified farm indebtedness
D. Qualified real property business indebtedness
E. Qualified principal residence indebtedness

Deferring Taxes With Qualified Real Property Business Indebtedness

In past weeks, we examined all except (D). Here we’ll examine that. The subparagraph (D) exception from income when “qualified real property business indebtedness” is discharged requires that the debt be secured by real property. That usually means a mortgage but may include other types of security such as a judgment lien or an unrecorded loan that is due on sale. The real property must be used by the debtor in a trade or business. A property that the debtor actively rents and manages would qualify as property used in a business, but a property subject to a passive triple net lease or fallow land probably would not qualify. The debt that is being discharged must have been incurred in connection with the property that secures the debt. For example, it is not qualified debt if a mortgage was taken out on an apartment building and the proceeds were used to build a factory on some other property. For any debts incurred since January 1, 1993, the debt can only have been incurred for the purpose of acquiring or substantially improving the real property that secures the debt. Debt can be refinanced without losing its status as qualified real property business debt. However, any cash taken out or used for other business purposes will not qualify. The amount of this exclusion from income is limited to the difference between the principal amount of the loan (not interest or other charges) and the fair market value of the property that secures the loan.

Whenever debt is forgiven without recognizing income, the taxpayer needs to offset the income that would otherwise have been recognized by reducing other tax attributes such as net operating losses, tax credits or the taxpayer’s basis in depreciable assets. If the debt that is forgiven is qualified real property business indebtedness, then the taxpayer must reduce the basis in depreciable real property. That property may be the property that secured the debt or it may be any other depreciable real property owned by the taxpayer (including real property inventory). The taxpayer cannot avoid recognizing income when qualified real property business indebtedness is forgiven beyond the amount of un-depreciated basis that is available to offset that income. Other tax attributes are not available to offset this type of discharged debt. However, when debt is discharged in a Chapter 11 action or while the debtor is insolvent, (a) by default the debt is offset against tax attributes other than basis; (b) the debtor can nevertheless elect instead to offset the phantom income against the depreciable basis of property that the taxpayer owns, which does not need to be real property; and (c) if the debtor does not have sufficient depreciable basis and other tax attributes to offset the phantom income, the taxpayer nevertheless can avoid recognizing income even on the excess discharged debt.

Although long for a blog, this discussion is actually brief. It is intended to draw attention to possible uses of IRC § 108, but if it should not be used as a substitute for direct examination of the law and consultation with experts.

Tax-Related Disclaimer: Any federal tax advice contained in this document was not intended or written by the author to be used, and it cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Any tax advice contained in this document may be held by the Treasury or the IRS to have been written to support, as that term is used in Treasury Department Circular 230, the promotion or marketing of the transactions or matters addressed by such advice because the author has reason to believe that it may be used or referred to by another person in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to one or more taxpayers. Before using any tax advice contained in this outline, a taxpayer should seek advice, based on the taxpayer’s particular circumstances, from an independent tax advisor.

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