A lot of real estate owners are having a rough time these days. Interest rates climbed, the effect of that has filtered into all corners of the economy, occupancy is slipping, and covering debt service gets hard. If that happens, your lender might decide to forgive some of the loan through a restructuring or a foreclosure. In this post, we’re going to look at the some of the tax rules that can keep you from paying extra taxes that you don’t need to. This is most important when you own commercial or multifamily property through a partnership.
When business owners hear that they’ll have to pay taxes on canceled debt, they have a few standard questions that Delancey Street hears all the time. It may seem like a win when a lender writes off part of a loan: “I don’t have to pay this piece anymore.” But according to the IRS, cancelled debt is counted as income, and that could mean a tax bill on money you never received.
When you borrow money, you are legally obligated to pay the money back to the lender. You and any co-borrowers are responsible for repaying the balance. If a lender forgives part of the debt, you are no longer obligated to repay the full amount. When lenders do this, they are canceling your debt. Lenders may cancel debt for reasons such as a borrower’s financial hardship, a foreclosure, repossessing property, or restructuring a mortgage. If your lender cancels debt, the IRS considers this income. Many lenders, including banks and other financial institutions, must report this to the IRS on Form 1099-C when the canceled amount is $600 or more. Whether or not it is taxable depends on your situation and the type of loan. If the loan is backed by collateral the tax you pay depends on what kind of debt it was.
Whether the Loan Was Recourse or Nonrecourse
If a bank forgives part of your loan and takes the property as collateral to settle the rest, the IRS sees that as a sale. How that sale is taxed depends on whether the loan was recourse or nonrecourse. If it was recourse, that means the borrower was personally liable for the debt, even beyond the value of the property. For example, if one or more of your partners had guaranteed the loan, that is recourse. When the lender sells the property, that fair market value is credited against the loan balance. If the lender cancels it, the remaining amount of the debt that exceeds the fair market value generally counts as ordinary income that is taxable, unless an exclusion applies.
Now say you’ve got a nonrecourse deal, which means the lender can only go after the collateral. If the debt was nonrecourse and the property is sold or foreclosed, the full outstanding debt generally gets added to the sales price. That bumps up your gain, which can be capital gain if you held the property for more than a year, subject to depreciation recapture and other rules. Whether you’d rather have ordinary income or capital gain treatment depends on your other tax attributes for the year, and every partner’s situation is different. Call your tax advisor and see what makes sense for you.
Restructure the Debt
If you can’t make the payments to your lender, one option is to restructure the debt. But restructuring that involves forgiving some or all of the remaining principal can lead to two big tax headaches. First, the forgiven principal is treated as ordinary income, which gets passed through to the partners and will likely mean taxable income. Second, when the lender forgives debt that a partner previously had tax basis for and used to take losses against, that reduces their outside basis. That can trigger an immediate taxable event or a larger capital gain down the road when they eventually sell their partnership interest. Bring your tax advisors into the loop before the restructuring. Once it’s done, there may be very little they can do to fix it.
Sometimes a restructuring is just not in the cards. Foreclosure may be the final outcome. In this situation, the partnership may recognize a gain on the foreclosure sale and may also have to recognize taxable income on the forgiven debt, based on the debt held at the time of foreclosure. Alternatives to foreclosure for a partnership can include asking its current investors to make capital contributions or seeking out new investors. A capital infusion can pave the way for a refinancing.
Possible Exclusions for Canceled Debt
Some taxpayers can exclude canceled debt from income, subject to limits and reporting on Form 982: taxpayers who are in a Title 11 bankruptcy case; insolvent taxpayers, to the extent of their insolvency; and those with qualified farm indebtedness. Even if you’re not in one of those categories, if you’re not a C corporation and the debt is qualified real property business indebtedness (debt tied to real property used in a trade or business and secured by that property), you can generally elect to exclude it too, subject to limits, although the excluded amount lowers the tax basis of the depreciable real property. There may also be an exception for qualified principal residence indebtedness that is discharged (or in a written agreement) before January 1, 2026.
A bipartisan bill, H.R. 5580, was introduced in the House in September 2023. It would change the tax code so commercial real estate borrowers could defer a tax on property investments after modifying their debt. The proposal aimed to address distress around commercial loan maturities; a bill’s introduction does not make it law. The tax code has a bunch of different things you can run into when part of a debt is forgiven or canceled, and business owners who aren’t aware of the options can end up making the situation worse by paying a tax that they didn’t need to pay. Make sure you contact your tax advisor before you make any decisions.
We’re Delancey Street, a business debt settlement company, not a law firm. If your business is under debt pressure and you are considering debt relief, think about the tax side before any lender forgives anything. Our senior advisors negotiate with lenders and funders for less than the full balance owed. An independent attorney or CPA hired separately can assess bankruptcy or tax questions. Your first consultation is free and confidential. On the first call, we discuss whether settlement may fit your finances.
