As published in Scotsman Guide's Commercial Edition, April 2011.
In today’s economy, renegotiating and reworking commercial-property financing is becoming more of a necessity. Property owners who have renegotiated loans may not know they do not simply receive a free pass from a tax perspective, however. Commercial mortgage brokers should be aware of the possible effects these renegotiations can have on their clients’ finances.
Renegotiating or discharging debt can be a great short-term strategy. The savings, however, may later need to be realized as income at tax time. A cancellation or reduction of debt may create a tax liability. The tax implications of renegotiating and discharging debt are nuanced and complex. These tax rules are summarized below. Commercial mortgage brokers should advise clients to seek professional tax guidance before making final decisions.
There are three general ways borrowers can surrender a property to discharge debt:
Foreclosure: This is a legal procedure for a secured lender to acquire the property.
Deed in lieu of foreclosure: This is a voluntary transfer of property to the lender in lieu of foreclosure.
Short sale: This is the sale of property to a third party for less than the debt owed to the lender.
The borrower may realize two types of income or loss when relinquishing a property in cancellation of debt. The first is gain or loss on the sale of the property. The second is cancellation of debt income, also known as discharge of indebtedness income. In either instance, the borrower will receive either or both of the following tax forms:
Form 1099-A, “Acquisition or Abandonment of Secured Property”
Form 1099-C, “Cancellation of Debt”
Both forms will state the fair market value of the surrendered property. Form 1099-A will state the amount of the outstanding debt as of the date of abandonment. Form 1099-C will state the amount of debt canceled.
The tax implications depend on whether the canceled debt is recourse or nonrecourse to the debtor. Recourse debt means the lender has legal recourse against the borrower for the debt. Nonrecourse debt means the lender’s only recourse is to take possession of the property that secures the debt. A loan can have a recourse provision for a limited amount and a nonrecourse provision that permits the lender to retain possession of the secured property.
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