11/14/2013 07:57 pm ET Updated Jan 23, 2014

Cancellation of Debt Income Can Mean Severe Tax Consequences for You and Your Commercial Property

For owners of distressed commercial real estate, loan restructuring, loan modifications or even foreclosure can be seem like a light at the end of a long and arduous tunnel, but one shouldn't be lulled into a false sense of security. Be aware that without ongoing proper tax planning, all that time, energy and money expended on those seeming solutions can result in a fairly hefty tax bill on top of a total loss of one's principal investment. This result can, however, often be mitigated if not avoided altogether. Arming yourself with knowledge of the current tax laws and how they might apply to your commercial loan restructuring or workout can aid you in planning for looming tax ramifications.

Application of Cancellation of Debt Income

In avoiding unexpected tax hazards, while negotiating with your lender, you must assess the applicability and potential impact of cancellation of debt income ("CODI"). CODI comes into play when part of your debt is forgiven or reduced, whether by a lender or through forced sale (e.g., foreclosure, short sale or deed in lieu of foreclosure). When all or some portion your debt is forgiven, for tax purposes, a gain is attributed to you in the same manner as if your commercial property were sold. (See IRC 61(a)(12)). This treatment of a "gain" is based on the principal that you have received an economic benefit commensurate with income, thus CODI is taxable at ordinary income rates. Let me repeat that; your "gain" is taxable at ordinary income rates. Depending on your adjusted tax basis, especially if you've rolled numerous investments through tax deferred 1031 exchanges (reference Dawn's other article) this number could be quite large.)

If your lender forgives all or part of your debt (e.g., resulting from a loan modification or workout), the gain to you is the amount reduced or discounted, taxable as CODI and reported on Form 1099-C. However, CODI only applies if your loan is a recourse loan (i.e., you are personally liable on the debt) and if you retained the collateral or property at issue. If the loan is indeed recourse, CODI must be included as ordinary income, unless an exception or exclusion applies. (See IRS Publication 4681).

Special Circumstances: "Forced Sales"

Application of CODI in the case of a forced sale depends on what type of loan you have, whether it is recourse or nonrecourse.

Recourse Loan. As mentioned, a recourse loan is one where a borrower is personally responsible for entire amount of the outstanding principal balance at the time of a default. Tax treatment for debt forgiveness on a recourse loan occurs in two ways: First, the forced sale is treated as a sale, subject to capital gain or loss. This is determined by calculating the difference between the fair market value ("FMV") of the foreclosure or appraisal price and your adjusted cost basis in the property. Second, because this is a recourse loan, you will incur CODI in the year the debt was forgiven, which is treated separately. CODI is calculated as the difference between the loan amount and the FMV selling price of your property. (See IRS Publication 4681).

Nonrecourse Loan. If you default on a nonrecourse loan, your personal assets are not at stake. The bank may only take the proceeds of your property to satisfy the commercial loan debt. Thus, there is only one step to tax treatment, excluding CODI. If there is a gain on the sale of your commercial property secured by a nonrecourse loan, you will incur capital gains tax on the difference between the loan balance and your adjusted basis. (See IRS Publication 4681).

"Bottom line...the first step in the commercial debt restructuring process is to understand your tax position if your distressed property involves debt forgiveness. This affords you the opportunity to avoid the hazardous tax consequences of CODI and any other associated taxes," explains Jack Rose, Chief Strategist at Breakwater Equity Partners. Once you know your impending tax hits, you may logically weigh all of your options. Consulting with a knowledgeable and innovative commercial real estate investment firm is essential in addressing all of your concerns, especially when faced with a potentially significant tax burden.

*Warning: This information is not intended to constitute legal, financial, or tax advice and should not be used in lieu of any professional's advice.