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 tax side of that and some of the ways to avoid 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. Lenders must report this to the IRS on Form 1099-C. 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. Whether or not that sale is taxable depends on whether the loan was recourse or nonrecourse. If it was recourse, that means you, personally, were responsible for paying it. 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. The remaining amount of the debt that exceeds the fair market value counts as ordinary income that is taxable.
Now say you’ve got a nonrecourse deal, which means the lender can only go after the collateral. If they cancel the debt in a sale of the property, the canceled amount gets added to the sales price. That bumps up your capital gain if you held the property for more than a year. 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. A partnership should look at alternatives to foreclosure, such as asking its current investors to make capital contributions or seeking out new investors. More often than not, a capital infusion paves the way for a refinancing.
Do Not Have to Report Canceled Debt as Income
There are some folks who do not have to report canceled debt as income: taxpayers who are in a Title 11 bankruptcy case; insolvent taxpayers; 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) then you can exclude it too, 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. Congress is looking to help relieve some of the distress that’s going to happen when a lot of loans are due soon and some of them will end up being defaulted on. 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. When bankruptcy or tax work is the right call we refer you to a vetted independent attorney. Your first consultation is free and confidential. If a less expensive path exists, we’ll let you know about it on the first call.
