Debt-forgiven commercial developers may face tax landmines

For struggling commercial property owners, loan modifications can be answered prayers, but without proper tax planning, all hell may break loose come April 15, 2010.

That’s because income from debt cancellation is taxable, something that is often overlooked as owners scramble to ward off financial ruin. Uninformed real estate owners could find themselves in financial peril when they file their IRS tax returns and owe hundreds of thousands of dollars in unexpected taxes they cannot afford to pay.

Consider the big picture: Commercial loan defaults are posting record-high rates — and momentum is moving toward worsening default rates in 2010. Real Estate Econometrics expects the default rate to rise to 5.2 percent by the end of 2010.

All this means heightened possibilities for commercial lenders working with overleveraged property owners to forgive a debt rather than waste more resources chasing insolvent borrowers.

“If the borrower is bankrupt, the bank will have no chance to recover the money on a recourse debt, and attempting to collect on a recourse debt from someone who is insolvent may exceed the benefits,” said Dennis Fitzpatrick, principal with Kaufman, Rossin & Co. in Miami. “Either way, to the extent that the lender forgives the debt, there is income to the borrower and it is taxable.”

If the lender forgives part of the debt, the owner sees a gain as if the property was sold. That gain is the difference between the fair market value of the property and the borrower’s basis, along with depreciation on any improvements. With declining market values in mind, the gain could be hundreds of thousands or even millions of dollars.

Although there are no escaping tax laws on the gain from a short sale, the good news is recent changes to tax codes allow borrowers to exclude cancellation of debt income from personal income taxes on recourse loans. The tax code gives companies looking to reduce or restructure debt the opportunity to defer the impact of COD income on debts occurring in 2009 or 2010 for a five-year period.

“This helps taxpayers that are working out their debt and may have losses this year but may have paid taxes in prior years,” said Ed Godoy, tax business line leader for the Miami office of BDO Seidman. “They may be able to carry back those losses and not be affected by this income inclusion and even get some refunds from prior years.”

Since public debt is frequently bought and sold by third parties, tax experts agree that the landmines are many in the area of forgiveness of debt. The bottom line: forgiveness isn’t always a good thing and what you thought was forgiven may come back to haunt you if loans are sold.

The first step in avoiding a financial explosion on the IRS front is for the borrower to understand his tax position based on the type of corporate entity that owns the property.

“Borrowers need to get into discussions with their lenders and understand the ramifications of these decisions,” Fitzpatrick said. “You need to know what the real cost is going to be of accepting debt forgiveness on a distressed property because there could be costs down the road that aren’t so obvious.”