Certified Specialist In Taxation Law
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Certified Specialist In Taxation Law |
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DISCHARGING DEBT ON YOUR APARTMENT BUILDING CAN BE DANGEROUS TO YOUR FINANCIAL HEALTH
With the depressed California real estate market, many rental real estate properties are in a position whereby the mortgage balance exceeds both the fair market value and tax basis of the property. Because of falling rents and the depressed market many rental real property owners see foreclosure as an economic alternative. Short sales, deeds in lieu of foreclosure, and loan reduction agreements are also seen as viable alternatives. The tax consequences among these alternatives may vary. Foreclosure of real property, through a trustee's sale, will produce taxable income to the extent that the loan balance exceeds the tax basis of the property in the year of sale. If the property owner is personally liable (ie., the loan is recourse) on the mortgage, then part of this transaction may be considered income from the discharge of indebtedness to the extent that the loan balance exceeds the fair market value of the property (see IRS Private Letter Ruling 9130005, IRS Revenue Ruling 90-16, and IRS Regulation 1.1001-2(a)(2) and example 8 thereunder; but see Chilingirian v Comm, 918 F.2d 1251 (nonjudicial foreclosure resulting in no discharge of indebtedness income), which is to the contrary; see also IRS technical advice memorandum 9302001, IRS regulation 1.1001-2(a)(4), Comm v Tufts, 461 US 300 and IRS Revenue Ruling 76-111 for the application to nonrecourse liabilities). Discharge of debt income is ordinary income and therefore taxed at regular rates. The lender will issue a form 1099-C if part of the transaction is considered as income from the discharge of debt. The property owner will have capital gain income in the amount of the excess of the fair market value of the property over its tax basis. For example, assume the property owner is personally liable on the mortgage, the loan balance is $900,000, and the property has a fair market value of $650,000 and tax basis of $600,000. Upon foreclosure through a trustee's sale, the property owner will have $250,000 of discharge of debt income and $50,000 of capital gain income. Deed in lieu of foreclosure transactions should generally produce the same results as a foreclosure transaction (see Bressi v Comm, 62 TCM 1668 and IRS Revenue Ruling 90-16). Under the Revenue Reconciliation Act of 1993 (amending IRC Sections 108 and 1017), a solvent noncorporate rental real property owner could elect to adjust the tax basis of the property disposed downward by the discharge of debt income, which has the effect of transforming the entire foreclosure transaction into capital gain income (taxed at a maximum of 28 percent for Federal income tax purposes). The debt discharged must be considered qualified real property business indebtedness (see IRS form 982 for a definition of qualified real property business indebtedness). The amount of discharged debt that can qualify under the new act cannot exceed the excess of the outstanding principal balance of the debt over the fair market value of the real property. The taxpayer will have to file a form 982 with his income tax return for the taxable year of the trustee's sale in order to elect to obtain the benefits of the new tax act (see IRS Temporary Regulation 1.108(c)-1T for further information on the election). To the extent a taxpayer is insolvent (ie., all of the taxpayer's liabilities exceed the fair market value of his or her assets), he or she may be able to completely exclude from taxable income, in the year of discharge, that portion of the transaction which is discharge of debt income. By virtue of the fact that many apartment owners have troubled properties, after determining their assets and liabilities, they may in fact be insolvent. Determining if, and by how much, the taxpayer is insolvent, is no easy task and will require advice from your tax advisor. The taxpayer, generally, will have to reduce certain tax attributes, like net operating loss and capital loss carryforwards, by the amount of the debt discharged in the year discharged. Alternatively, under the insolvency exception, the taxpayer may elect to first reduce the tax basis of certain other properties, including rental properties, owned as of the first day of the following tax year (see IRC Section 1017(a); IRS publication 908, pg. 2; but also see regulations under section 1017 and S. Rep. No. 1035 fn. 62). The insolvency exception, which allows the taxpayer to exclude from taxable income the discharge of debt amount, should be contrasted with the new provision provided in the Revenue Reconciliation Act of 1993. Under the new act, the insolvency exception takes precedence over the qualified real property business indebtedness exclusion. With the insolvency exception, it appears that the basis reduction could take place in the beginning of the taxable year following the taxable year of discharge, even if property, which secured the debt, was disposed of in the current taxable year (see IRS publication 908, page 2 under the heading "when to make the basis reduction"). This gives rise to obvious planning possibilities because any assets disposed of during the current taxable year of the discharge are not subject to basis reduction. However, if the property owner is solvent, disposes of the property securing the debt during the current tax year, and incurs discharge of debt income, the entire discharge of debt amount would be included in taxable income in the year in which the property is disposed. This is because the new tax act requires adjustment to the tax basis of the property disposed of in the year of disposal (see IRC Section 1017(b)(3)(F)(iii)). In contrast, under the insolvency exception, because it takes precedence over the qualified real property business indebtedness exclusion, the entire discharge of debt income could be excluded from the taxable income of an insolvent taxpayer in the year of discharge. When the property owner undergoes a short sale it should be treated as above, with the sales price being equivalent to the fair market value if the transaction is arms length. If the property owner enters into a bankruptcy, and a discharge of debt occurs thereunder, the property owner may also be able to exclude the entire discharge of indebtedness from taxable income (see IRS Private Letter Ruling 8918016). The particulars of the tax effects of a bankruptcy is beyond the scope of this article. Before entering into a bankruptcy, you should also consider the various tax effects. If a solvent property owner negotiated a reduction in the secured loan amount, whether or not he was personally liable on the loan, and without disposing of the property securing the loan, then under the Revenue Reconciliation Act of 1993, the property owner could avoid including into their taxable income the discharge of debt amount. Generally, the property owner must elect to adjust the tax basis of the property securing the debt (see IRS regulations under 1017) by filing a form 982 with his income tax return for the taxable year of the discharge. For partnerships, the rules for exclusion from gross income and reduction of tax attributes are to be applied at the partner level and not at the partnership level. Thus, income is not excludable at the partnership level, but at the individual partner level. In addition, insolvency is determined at the partner level. The determination, however, of whether a debt is qualified real property business indebtedness is made at the partnership level in the case of discharge of partnership debt. If a partner elects to, or must, reduce the tax basis of partnership real property, the partner's proportionate interest in the tax basis of the property held by the partnership must be reduced. If the owner is a limited partner, some of the above calculations may be different. The form 982 is attached to the partner's individual return, and not the partnership return. The bottom line is that property owners should determine the tax effects of the various alternatives prior to deciding how they will handle a particular troubled property. The tax effects can be costly, yet in some cases the property owner may be able mitigate those effects with the right tax planning. Property owners should be straight on the tax effects among the various alternatives before deciding on how to dispose of their troubled property or before working out a loan with their lender. The rules pertaining to personal residences are different, and can be more severe. Before entering a similar transaction with your personal residence the tax effects should be analyzed.
Michael D. Daniels
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