It is estimated that in excess of one trillion dollars of commercial real estate mortgages are scheduled to become due between this year and 2013. Many lenders are seeking to restructure these loans. Moreover, borrowers who believe in the long-term value of their property are initiating restructuring efforts with their lenders. These workouts generally take two approaches. Those initiated by the debtor generally involve the debtor retaining the property that secures the debt. Others involve a transfer of property, which has a value less than the debt, in full satisfaction of the borrower’s liability.
These transactions, dictated by business necessities, involve complex tax rules. The key tax principle involved is that the initial receipt of borrowed funds does not result in income to the borrower because of the offsetting liability created. However, if that offsetting liability is reduced without full repayment by the debtor, the tax result is that the borrowed funds have increased the debtor’s net assets. Since 1931, federal income tax laws have recognized that discharge of debt for less than its face amount could generate tax gross income. Notwithstanding the long period during which this principle has applied, the application of income tax rules to loan workouts is often uncertain. The tax provisions most often implicated in real estate restructuring efforts are transfers of property by foreclosure or deed in lieu transactions; the exclusion of gross income from cancellation of liabilities to the extent of the taxpayer’s insolvency; and the ability of the taxpayer to defer income from a reduction in liabilities at the cost of reducing the tax basis of depreciable real property. This article will focus on those rules.
Disposition of property
Frequently loan workouts result in a loss of ownership of the property by foreclosure or deed in lieu of foreclosure either to the lender or a third party designated by the lender. In these transactions, the tax consequences vary depending on whether the debt is characterized for income tax purposes as “recourse” or “nonrecourse.” Indebtedness is generally classified as nonrecourse if the lender’s remedies are limited to particular collateral and as recourse if the borrower has personal liability. 1 When calculating a partner’s tax basis, Reg. 1.752-2 contains rules for classifying debt as recourse or nonrecourse that rely generally on the individual’s liability to pay in the event of default. These rules, however, are generally not considered to govern for purposes of Section 1001 dealing with sales or exchanges of property. Reg.1.1001-2 characterizes an exculpatory liability (those generally incurred by limited liability companies (LLCs)) as a recourse liability. However, in some cases, courts have looked to the regulations under Section 752. 2
In determining the classification of debt, state law rules that determine the legal rights of the parties are relevant. Ultimately, however, the classification of a liability for federal income tax purposes as recourse or nonrecourse is a federal income tax issue, and in many cases, the answer is less than clear. For example, under some state laws, a debt is considered nonrecourse only if it specifically so provides. LLC debt can be pursued only against the assets of the company. Thus, such debt cannot be pursued against an owner of the company. It is not clear, under current law, whether an LLC loan that does not specifically provide that it is nonrecourse should be viewed as nonrecourse debt. The author’s view is that if the rights of the creditor with respect to property are no greater than the rights that would obtain if the debt specified it was nonrecourse, the debt should be treated as nonrecourse for federal income tax purposes. However, if the debt is to be nonrecourse for federal income tax purposes, counsel would be well advised to so specify.
Also uncertain is the classification of a loan that is nonrecourse to the borrower, but that is backed in whole or part by a guarantee of payment from an owner or third party. A partial guarantee is probably the most common situation giving rise to a partially recourse debt. The Service has held in at least one private letter ruling 3 that payments in settlement of partially recourse debt should be allocated first to the nonrecourse portion of the debt. It is not clear that this principle is applicable to so-called “bottom guarantees.” For example, if the liability is $1,000, the debtor might guaranty $200 of the debt under terms that will require the debtor to honor the guaranty only if the collateral cannot be sold for at least $200. If the recourse liability is eliminated by the first dollars collected on the liability, it would seem that the recourse amount of the debt should be treated as paid. Often, otherwise nonrecourse liabilities contain “recourse carve-outs” that vary from those that are limited (e.g. environmental liabilities) and others that may be so broad as to raise the issue as to whether the loan should be characterized as recourse. The uncertainty regarding the characterization of a liability is significant because there are markedly different tax consequences between a transaction treated as a sale of property and one that is a debt cancellation.
If the debt is nonrecourse, the full amount of the debt is treated as the taxpayer’s amount realized on the disposition of the property in a deed-in-lieu of foreclosure transaction. The debtor will realize taxable gain or loss equal to the difference between the outstanding principal of the debt and the debtor’s adjusted tax basis in the underlying property.
Example: Assume that Ace Group purchased property for $10 million. When the property appreciated to $25 million, Ace increased the nonrecourse debt on the property to $20 million. If, at the time of foreclosure, the tax basis of the property is $5 million and its fair market value is $10 million, Ace will realize a gain of $15 million.
The Supreme Court has determined that the fair market value of the property is not a relevant factor. 4 Thus, to the extent that the amount of the debt secured by the property exceeds the tax basis of the property—a not uncommon fact pattern today—the debtor will recognize gain without the receipt of cash.
If the debt is recourse, the transaction (and the characterization of the debt) is bifurcated. In general, the transfer of the property is treated as a deemed sale of the property resulting in gain or loss to the debtor to the extent of the difference between the fair market value of the property transferred and its income tax basis. The balance of the liability is treated as personal debt. Absent some exclusion, cancellation of the personal debt by the lender is treated as cancellation-of-debt (COD) income to the debtor.
Example Assume the same facts as in the previous example except that the $20 million debt is a recourse liability. The deed in lieu of foreclosure will result in a bifurcation of the transaction into a sale of the property for $15 million, resulting in a realized gain of $10 million. Ace has COD income of $5 million.
In general, absent clear and convincing proof to the contrary, the sale price of the property at a foreclosure sale is presumed to be the fair market value. However, there have been workout cases in which taxpayers have successfully argued that the value is less in order to have a greater recourse liability and take advantage of the exclusion from COD income to the extent the taxpayer is insolvent or to the extent that payment of the liability, such as accrued interest, would give rise to a deduction.
COD income is taxed as ordinary income, but there are several exclusions and still other Code provisions providing that the recognition of COD income is deferred. In many cases, taxpayers will prefer sales gain to the receipt of COD income because of the preferential tax rates applicable to capital gains or the availability of capital loss offsets to such income. However, sale treatment will produce a less favorable result (1) if the debtor can qualify for exclusion from tax of the COD income; (2) there is an available net operating loss that cannot otherwise be used; or (3) the debtor, for cash flow reasons, wishes to elect an available deferral of recognized COD income to a future tax year. 5
Example: Assume the same facts as in the previous example except that Ace has a net operating loss of $6 million from the operation of its real estate business. The COD income will be offset by that loss. However, if the debt was nonrecourse, the entire $20 million gain would be recognized. That gain would most likely be a Section 1231 gain and taxed as capital gain.
If COD exclusions are otherwise available (generally because of insolvency), nonrecourse borrowers have sought to structure transactions to trigger COD rather than suffer sale or exchange gain. Among the strategies that taxpayers have used are:
Negotiating a reduction in the nonrecourse debt prior to foreclosure in order to report COD rather than capital gains on the amount by which the nonrecourse liability is reduced.
Transferring cash equal to the current value of the collateral instead of transferring the collateral and recognizing COD income on the excess.
Selling the collateral and transferring the sale proceeds to the lender, recognizing gain or loss on the sale of the property measured by the difference between the sale proceeds and the tax basis of the property and recognizing COD income measured by the amount that the liability exceeds the payment to the lender.
The risk in all of these approaches is that the first transactions and the subsequent discharge of debt will be treated as step transactions and the entire transaction treated as a transfer of the property in exchange for the nonrecourse debt, resulting in the balance of the debt being the proceeds of the transaction. This risk is heightened by the need almost invariably to obtain the lender’s consent to any such transaction.
The step transaction risk is illustrated by the Fifth Circuit’s decision in 2925 Briarpark Ltd. 6 In that case, a taxpayer relying on the Tax Court decision in Gershkowitz 7 that cancellation of nonrecourse debt without the transfer of the collateral securing the debt will be COD income, attempted to change gain recognition on the sale to COD income (presumably because of the insolvency of the partners) by somewhat disconnecting the COD transaction from the subsequent sale of the property. The Tax Court and the Fifth Circuit agreed with the IRS that the debt and the subsequent discharge should be stepped together and the transaction treated as a conveyance of the property in exchange for the nonrecourse debt, resulting in the entire difference between the balance of the debt and the adjusted basis of the property being characterized as taxable gain (and not COD).
Releases of guarantees of debt are not treated as a cancellation of debt for purposes of COD income recognition. The provisions dealing with cancellation of debt do not apply because the release of a guaranty does not enhance the taxpayer’s wealth by eliminating a liability associated with the prior receipt of loan proceeds.
A debtor may be able to work out a restructuring of his or her debt and retain the property. In such case, the applicable tax rules are the same without regard to whether the debt is recourse or nonrecourse. 8 If there is a significant modification of the terms of the debt (regardless of whether there is a reduction in the principal amount), Section 1001 will result in the restructuring of the debt being treated for federal income tax purposes as an exchange of the old debt obligation for a new debt obligation to which the original issue discount rules will apply. The deemed exchange will result in COD income to the debtor if the “issue price” for tax purposes of the new obligation is less than the “issue price” for tax purposes of the old debt.
For example, if a debt that carries a 4% interest rate is materially modified when the interest rate for determining whether the principal of the debt reflects original issue discount (OID) is 8%, the modified debt treated as principal for income tax purposes is reduced by the present value of the 4% OID rate difference and the new issue price will be less than the original issue price even though the stated interest rate has not been modified. The difference between the original issue price and the reduced issue price will be COD income. Recently, the IRS has proposed changes in its regulations that make it clear that the mere deterioration in the financial condition of a debtor will not cause a significant modification of a debt instrument (e.g., its characterization as equity) if there is not otherwise a significant modification such as a change in the obligor or addition or deletion of guarantees. 9
An amount otherwise includable in income as COD income is excluded under Section 108 if the discharge occurs in a bankruptcy proceeding under Title 11 or similar provision. It is also excluded in an out-of-bankruptcy restructuring if the taxpayer is insolvent, except to the extent that the restructuring renders the taxpayer solvent.
Example: Assume that Ace acquires its $20 million debt obligation for $10 million when it is insolvent for tax purposes by an amount of $7 million. Ace will be rendered solvent by $3 million, and that amount will be COD income. The $7 million balance will not be income because of Ace’s insolvency.
Section 108(a)(1)’s insolvency exception codified judicial decisions holding that debt cancellation does not result in income if the taxpayer’s freed-up assets leave the taxpayer with liabilities in excess of the asset’s value. The statutory exclusion from income is at the cost of the taxpayer’s reducing certain favorable tax attributes up to the lesser of the excluded COD income or the amount of the tax attributes.
Section 108(d)(3) defines insolvency as the “excess of liabilities over the fair market value of assets.” This determination is informed by court decisions and IRS rulings, but remains one of the more opaque issues in determining the tax consequences of a debt restructuring. In Ltr. Rul. 9125010, the IRS states that “Congress intended to codify the judicially developed insolvency exception,” which was based on the “freeing of assets.” The focus on net assets available to creditors set out in Ltr. Rul. 9125010 is reflected in the Tax Court’s decision in Hunt. 10 In determining the extent of the Hunt children’s solvency, the Tax Court had to determine the extent of the value of property exempt by state law from creditor claims because the court held that such assets were not freed from creditor claims by reason of debt cancellation. Therefore, they were to be taken into account in determining whether the taxpayer was insolvent.
Rev Rul. 92-97
Rev. Rul. 92-97 analyzes two factual situations. Under the first scenario, two partners, A and B, had contributed $90 and $10 respectively on the formation of a general partnership. The partnership borrowed an additional $900 on a recourse basis to acquire property. A bore the risk of loss for $810 of the debt and B bore the risk of loss for $90 of the debt, and the liability was allocated among the partners accordingly under Section 752. The partnership allocated deductions and losses 90-10 between its two partners but allocated income and gain between the partners 50-50. The $900 debt obligation was discharged as part of a workout when the property was fully depreciated. Therefore, A’s capital account was negative by $810 and B’s was negative by $90 at the time of the discharge. The partners were obligated to restore deficit capital accounts only to the extent necessary to pay creditors, so the deficit restoration obligations of A and B were eliminated when the partnership’s liability was discharged.
If the income from the discharge of the liability had been allocated 50-50 pursuant to the terms of the partnership agreement, A would have wound up with a negative capital account balance equal to $360 (($810) + $450), and B would have had a positive capital account equal to $360 (($90) + $450). However, because A had no obligation to fund B’s capital account by restoring A’s capital account deficit, such an allocation would not have had economic effect. Accordingly, Rev. Rul. 92-97 holds that the only allocation that would have had economic effect would have been an allocation in accordance with how the partners had shared the liability; that is, $810 to A and $90 to B. Such an allocation would have left each partner with a capital account balance of $0.
Under the second scenario considered in Rev. Rul. 92-97, the facts are exactly the same, except that A and B both had unlimited deficit restoration obligations. Under this scenario, the Service held that a 50-50 allocation of the COD income between A and B did have economic effect because A would be required to fund B’s positive capital account. In other words, there were real economic ramifications to the allocation.
Section 108(d)(6) requires that the determination of insolvency under Section 108(a)(1)(B) be made at the partner level. For the purpose of determining the insolvency of the debtor taxpayer for federal income tax purposes, the value of assets is the fair market value determined using the arms-length pricing between a willing buyer and willing seller. That standard is one employed in many tax law provisions. However, there are a number of significant issues in making this determination. One of the controversial issues is whether assets exempt from the reach of creditors are assets excluded in the insolvency computation. This issue has arisen in the context of state law exclusions of assets that creditors can reach. However, the issue also exists in the context of federal law exclusions of assets from creditor claims—importantly, assets in qualified pension, profit sharing, and 401(k) plans, and in IRAs.
Initially the Tax Court held that assets exempt under state law were excluded in the calculation of solvency. In recent decisions the Tax Court has addressed the issue squarely and rejected the prior decisions. 11 In Hunt, the court ruled that the exemptions in the bankruptcy law were not available to taxpayers who claimed the insolvency exemption because they were not in bankruptcy. In Carlson, taxpayers purchased a fishing vessel and financed that purchase with a mortgage. After they were delinquent in making payments to the bank on the loan, the bank foreclosed on the vessel, sold it as part of the foreclosure, used the proceeds from the sale to reduce the outstanding principal balance of the loan and discharged the remaining balance of the loan. As a result, the taxpayer realized capital gain of $28,621 and discharge of indebtedness income (DOI) of $42,142. The taxpayers excluded DOI income from their gross income on the basis of the insolvency exception. In making that determination, they excluded certain assets on the basis of their exemption from the claims of creditors under applicable state law. The court concluded that there is no judicially developed insolvency exception to the general rule of Section 61(a)(12) that gross income includes income from the discharge of indebtedness. In effect, if the taxpayer has net assets, a tax on COD income is imposed. Although the argument for excluding assets that Congress has insulated from creditor claims in determining a taxpayer’s solvency may be stronger, absent rulings or decisional law, taxpayers should be cautious in assuming a different conclusion from the one reached with respect to assets protected by state law.
Significant uncertainty also surrounds the effect of contingent liabilities in determining a taxpayer’s insolvency. The Ninth Circuit in Merkel, 12 in affirming a Tax Court decision, held that “a taxpayer claiming to be insolvent for purposes of §108(a)(1)(B) and challenging the Commissioner’s determination of deficiency must prove by a preponderance of the evidence that he or she will in fact be called upon to satisfy the contingent liability and that the total amount of liabilities exceeds the value of the taxpayer’s assets.” In that case, the taxpayers had guaranteed a loan made by a bank computing business that they owned. At no time did the bank make any formal written demand for payments pursuant to the guaranty.
Another issue that has not been fully plumbed is the effect of nonrecourse liabilities on the determination of the taxpayer’s solvency. In Rev. Rul. 92-53, 13 the Service ruled that the amount by which a nonrecourse liability exceeds the fair market value of the property securing the debt (excess nonrecourse debt) should not be treated as a liability for purposes of determining insolvency to the extent that the excess nonrecourse debt is discharged. If the nonrecourse debt is not being discharged, the debt should be treated as a liability in determining insolvency only to the extent of the fair market value of the property securing the debt.
Example: Assume that Ace owns property subject to a $20 million mortgage, which it satisfies for $8 million. Ace also owns properties with a value of $30 million subject to nonrecourse debt of $37 million. In determining if the taxpayer is insolvent, the $12 million debt being cancelled can be taken into account as if it were a recourse liability. The $7 million nonrecourse debt liability in excess of the fair market value of the taxpayer’s other assets is not taken into account.
The IRS rationale for permitting nonrecourse debt that is being restructured to be taken into account in determining insolvency is its view that Congress wanted the insolvency exclusion to provide a taxpayer with a “fresh start” following a workout similar to that provided in bankruptcy. The nonrecourse debt rule has had a significant impact on current restructurings. Often, in current restructurings, the lender is discounting the nonrecourse debt by 50% or more. As a result, those whose other assets are significantly leveraged may not have difficulty in satisfying the insolvency definition because of the magnitude of the “excess nonrecourse debt” being cancelled.
An issue with respect to nonrecourse debt is the manner in which the potential tax liability in so-called overmortgage situations should be treated. The excess of the nonrecourse debt over the tax basis of property will trigger a gain and a tax liability if the property is transferred to the creditor. Unlike the loss in the value of the property, the tax cost is not one borne by the lender.
Example: Assume the facts in the prior example and that the tax basis of Ace’s other property is $5 million. If Ace lost its property, it would have a gain of $32 million ($37 million of nonrecourse debt proceeds less $5 million of tax basis). Assuming a 40% tax rate, the tax liability would be $14.8 million. Because that liability is not that of the nonrecourse lender, it would seem that the amount of such potential liability should be taken into account in determining whether the taxpayer has assets available to pay creditors and is therefore solvent.
Another issue with respect to which there is an absence of definitive authority is the impact of a partner’s partnership interests on the insolvency determination. Although Section 752 provides for the allocation of liabilities among partners, the rules of Section 752 do not always reflect how the responsibility for partnership liabilities will ultimately be shared. For example, Rev. Rul. 92-97 14 deals with the economic effect requirement of allocations when the partnership agreement allocates COD income in a manner that is different from how the partners share the debt. The revenue ruling indicates where the responsibilities for debt will not follow the partnership allocation of profit and loss because the allocation does not have substantial economic effect.