Taxable Income and Debt Cancellation
If you have a $80,000 loan and the bank reduced the amount you owe down to $50,000, then you have an economic benefit of $30,000, which should be treated as taxable income. This is indeed how cancellation of debt is treated, but there are exceptions such as in the case of bankruptcy or insolvency. There is another unique scenario that applies only to commercial real estate.
Assuming that the taxpayer is not a C-corporation, debt cancellation is excludable from taxable income if it results from qualified real property business indebtedness (QRPBI). QRPBI is debt taken on to buy real property used for commercial purposes. Starting in 1993, debt used for building or improving a property also qualify.
As we all know, there is no such thing as a free lunch. In order for debt cancellation to not be considered current taxable income, the taxpayer must reduce their basis in the real property by this same amount. This does not cancel the income; instead, it defers its recognition and helps cash flow as a result. Below, we look at an example of how this works.
Illustrative Example
Assume David bought a property in 2017 and he uses it for business purposes. In 2022, the property has a first mortgage of $200,000 and a second mortgage of $100,000 (both with the same bank), with a fair market value (FMV) of $240,000. He negotiates with the bank to reduce the second mortgage down to $20,000, resulting in income from the cancellation of debt of $80,000.
The amount of debt cancellation that can be deferred is equal to the amount of the second mortgage before the debt cancellation, less the FMV minus the first mortgage. In David’s case, before debt cancellation, the FMV ($240k) minus the first mortgage ($200k) was $40,000. The balance of the second mortgage ($100k) exceeded this by $60,000. Out of the total debt cancellation of $80,000, this $60k is subject to deferral, with only the remaining $20,000 reported as immediate taxable income.
The $60,000 is not considered as taxable income only to the extent that David has sufficient adjusted tax basis in the depreciable real property to absorb this as a reduction in basis. Assuming this is the case, the reduction in basis applies the first day of the tax year after the debt cancellation (unless the property is sold before year-end – then it applies immediately).
In the example above, David would include the $10,000 of cancellation of debt income on his 2022 tax return and adjust his basis in the real property by $60,000 as of Jan. 1, 2023.
Filing Mechanics
For real estate held via partnerships instead of by individuals, determining if debt is QRPBI qualified happens at the entity level, although reductions of basis are done at the individual level for each partner, allowing individual planning. The election to defer cancellation of debt income is recorded on Form 982.
Conclusion
The COVID pandemic caused many real estate investors to restructure their debts. The option to defer debt income cancellation offers a great tax planning opportunity by delaying taxable income and improving cash flows.
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If you have a $80,000 loan and the bank reduced the amount you owe down to $50,000, then you have an economic benefit of $30,000, which should be treated as taxable income. This is indeed how cancellation of debt is treated, but there are exceptions such as in the case of bankruptcy or insolvency. There is another unique scenario that applies only to commercial real estate.
Assuming that the taxpayer is not a C-corporation, debt cancellation is excludable from taxable income if it results from qualified real property business indebtedness (QRPBI). QRPBI is debt taken on to buy real property used for commercial purposes. Starting in 1993, debt used for building or improving a property also qualify.
As we all know, there is no such thing as a free lunch. In order for debt cancellation to not be considered current taxable income, the taxpayer must reduce their basis in the real property by this same amount. This does not cancel the income; instead, it defers its recognition and helps cash flow as a result. Below, we look at an example of how this works.
Illustrative Example
Assume David bought a property in 2017 and he uses it for business purposes. In 2022, the property has a first mortgage of $200,000 and a second mortgage of $100,000 (both with the same bank), with a fair market value (FMV) of $240,000. He negotiates with the bank to reduce the second mortgage down to $20,000, resulting in income from the cancellation of debt of $80,000.
The amount of debt cancellation that can be deferred is equal to the amount of the second mortgage before the debt cancellation, less the FMV minus the first mortgage. In David’s case, before debt cancellation, the FMV ($240k) minus the first mortgage ($200k) was $40,000. The balance of the second mortgage ($100k) exceeded this by $60,000. Out of the total debt cancellation of $80,000, this $60k is subject to deferral, with only the remaining $20,000 reported as immediate taxable income.
The $60,000 is not considered as taxable income only to the extent that David has sufficient adjusted tax basis in the depreciable real property to absorb this as a reduction in basis. Assuming this is the case, the reduction in basis applies the first day of the tax year after the debt cancellation (unless the property is sold before year-end – then it applies immediately).
In the example above, David would include the $10,000 of cancellation of debt income on his 2022 tax return and adjust his basis in the real property by $60,000 as of Jan. 1, 2023.
Filing Mechanics
For real estate held via partnerships instead of by individuals, determining if debt is QRPBI qualified happens at the entity level, although reductions of basis are done at the individual level for each partner, allowing individual planning. The election to defer cancellation of debt income is recorded on Form 982.
Conclusion
The COVID pandemic caused many real estate investors to restructure their debts. The option to defer debt income cancellation offers a great tax planning opportunity by delaying taxable income and improving cash flows.
DisclaimerÂ
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact a professional regarding the topics in these articles. The images linked to these articles are protected by copyright and should not be copied for any reason.
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