Publications: Income tax issues in today's real estate market

Current economic conditions have placed incredible financial pressure on commercial real estate. The following discussion provides an introduction to some of the recurring income tax issues that are being encountered in this environment.

1) The property owner (assumed to be a partnership for income tax purposes) still controls day-to-day operations. However, net operating income is insufficient to support the current mortgage and is unlikely to increase in the foreseeable future.

The first issue is whether the mortgage holder should be treated for income tax purposes as the "owner" of the property. The fact that the current owner still holds legal title coupled with the absence of any identifiable event that establishes a change of legal ownership suggests that it is unlikely that the IRS will raise this argument.

Assuming that the owner/partnership reports on the accrual basis, the next issue is whether the owner can continue to accrue interest expense, real estate taxes, and other expenses that are not being paid currently and will probably never be paid. The technically correct answer is "no," although it is unlikely that this is what commonly occurs. To the extent tax losses are claimed by the members, there is some risk that these returns will be audited, the losses disallowed, and tax deficiencies, interest and penalties asserted.

2) The owner/partnership decides to file for protection in bankruptcy court.

The fact that the partnership files for bankruptcy has no immediate effect for income tax purposes; the partnership's tax year continues, and its partners' income tax status is unchanged.

A reduction of debt without full payment triggers "cancellation of indebtedness" income for tax purposes. Cancellation of indebtedness income in this context is that it is taxed at ordinary rates as opposed to capital gains rates. Generally, a bankrupt person does not have to recognize any cancellation of indebtedness income as taxable income. However, in this context, the partners not the partnership are the ultimate taxpayers and, unless they independently qualify for some relief, any reduction of debt will result in each of the partners being charged with ordinary income.

As a practical matter, bankruptcy is rarely filed where a single property is involved since it is unlikely that bankruptcy will provide meaningful relief from secured creditors' claims, the bankruptcy process is expensive, it rarely addresses personal guarantees of the debt and generally bankruptcy has no income tax advantages.

3) The property is either foreclosed upon or transferred using a deed in lieu.

For income tax purposes, this is treated as a sale of the property. If the mortgage is entirely nonrecourse, the property is deemed to have been sold for the amount owed (principal and accrued interest) and the partners recognize taxable gain from the deemed sale. This gain is classified for income tax purposes as "Section 1231 gain," which is generally taxed at long capital gains rates (currently 15 percent for federal purposes, but scheduled to increase to 20 percent Jan. 1). To the extent the gain involves "recapture" of prior depreciation, the tax rate is 25 percent. Foreclosure frees up any suspended passive losses (generally ordinary) so there may be some tax arbitrage benefit.

If the mortgage is recourse, those bearing personal liability risk either having to pay the lender the deficiency or attempting to negotiate a settlement at a reduced amount. Settlement at a reduced amount may result in cancellation of indebtedness income. Guarantors should be able to avoid cancellation of indebtedness income by claiming that the obligation under the guaranty was contingent and/or that there were valid defenses to it.

The net effect of this is, of course, the partners generally end up with a tax bill with no cash proceeds to pay it. Foreclosure can also adversely affect real estate promoters when they apply for loans on other properties.

4) The mortgage is renewed or extended but principal reduction and/or personal guarantees are required.

Assuming that the property is performing reasonably well, it may be possible to renegotiate the mortgage. Unfortunately, lenders impose a price for this; claiming that the value of the property securing the loan has decreased significantly. Accordingly, lenders often require (i) a reduction of principal, which can only be funded through capital contributions from the members, and/or (ii) personal guarantees of a portion of the indebtedness. Although the promoter of the project may be willing to make these contributions, passive investors will generally refuse to do so.

If additional equity is contributed to the property, it will be used to reduce the outstanding principal balance. In these circumstances, it is possible that the partners who do not contribute toward this indebtedness will be charged with income or gain on the theory that their share of the underlying indebtedness has been diminished. A similar result obtains when personal guarantees are provided since this recharacterizes what was once nonrecourse debt (shared ratably among the partners) into recourse debt (shared only by those partners bearing an economic risk of loss).

Thus, noncontributing partners end up with a net economic outlay in the form of "recapture" taxes. That raises issues concerning fiduciary obligations owned to the noncontributing partners. Further, there is the additional issue of what additional compensation should be given to the partners who contributed additional equity or assumed more risk.

5) The lender is admitted as a new partner for a reduction of its loan, or is given some sort of "equity kicker" to compensate it for agreeing to renewal.

Sometimes, but rarely, the lender is willing to cancel a portion of its loan in exchange for an equity interest in the partnership. Alternatively, in lieu of converting some of the debt to equity, the lender will require some form of "equity kicker."

If the lender's status changes from being a mere creditor to being a "partner," all of the members of the partnership will be adversely affected since the tax benefits that they previously claimed based on an allocation of the underlying loan will be "recaptured." That is, the formerly nonrecourse loan will be converted to a loan that is recourse to the lender/partner. Note that grants of options, warrants or similar rights to a lender can create a similar problem for the partners since such rights may permit the IRS to argue that the lender has become a "partner" for income tax purposes.

The lender's alternative is to permit deferred payments of interest at a higher interest rate, provide for contingent interest, or in some other fashion enhance its return without taking an equity interest. That, unfortunately, can give rise to cancellation of indebtedness income.

6) The lender is willing to simply reduce the amount of its claim.

Sometimes a lender is willing to simply reduce the outstanding indebtedness; generally in consideration for a substantial pay down or a complete refinancing. This triggers cancellation of indebtedness income, which is characterized for tax purposes as ordinary income and is allocated to each of their partners as though it was realized by them individually. Partners who are individuals may be able to avoid recognition of cancellation of indebtedness income by making an election to adjust the income tax basis for their respective interests in the property. In effect, the partners write down their tax basis and give up future depreciation allowances in lieu of recognizing income currently. Corporate partners do not have this option, although, under current law, it is possible for them to defer recognition of the cancellation of indebtedness over a term of five years.

One final cautionary note: Changes in ownership involving more than 50 percent of the beneficial interests and foreclosures by junior lender might trigger fairly substantial city, state and county transfer taxes.