What Distressed Property Owners Might Expect From the IRS

The commercial real estate market has been rough for some time, and the residential market has seen wild fluctuations. Factors like inflation, high interest rates and decreased demand for office space have contributed to these trends. One result is that the market has seen a rise in the number of distressed properties.

This is especially true for commercial office properties. According to the Urban Land Institute, three U.S. metro areas had delinquent office properties over $1 billion as of late 2023. New York City led the group with more than $2.3 billion in delinquencies. Distressed property owners might have several options for relief, but each one carries tax consequences.

This article will discuss what makes a property “distressed,” how property owners can deal with distressed properties and how it could affect their taxes. A tax professional can help you understand your options in your particular situation.

Distressed Property Defined for Tax Purposes

Federal tax law does not have a specific definition of a “distressed property,” but some states may define it for state tax purposes. Generally speaking, a distressed property is near or in foreclosure. Properties become distressed when the owner cannot continue to make payments to their lender or pay property taxes. This includes residential properties with mortgages and commercial properties with other types of loans.

Options for Owners of Distressed Property

Distressed property owners may have several options for dealing with their situations. They may want to keep the property while restructuring the debt, or they might be willing to part with the property if it means satisfying the lender.

Scenarios in which a distressed property owner keeps the property include negotiating the following with their lender:

• • Reducing the principal loan amount and resuming payments;
  • Settling on a lower payoff amount; or
  • Modifying other loan terms, such as reducing the interest rate or making interest-only payments for a limited time.

The owner might have the following options for disposing of the property:

• • Selling it to pay off the loan;
  • Surrendering it to the lender through a deed in lieu of foreclosure; or
  • Allowing it to go into foreclosure.

Not all of these options will be available to every property owner. The available options and ideal course of action will depend on factors like the nature of the debt, the debt amount, the property’s value, the owner’s tax basis and whether the owner is solvent. If the owner is insolvent, their options may depend on whether they have already filed for bankruptcy.

Tax Consequences When a Property Owner Keeps a Distressed Property

When a distressed property owner keeps the property while modifying or paying off the debt, a key tax consideration is how the IRS will view any reduction in the debt amount.

Discharge of Indebtedness

Under the Internal Revenue Code, discharged debt is taxable income. Exceptions apply, of course, such as discharges of debt in certain bankruptcy cases and the discharge of qualified real property business indebtedness (QRPBI).

Debt may count as QRPBI if it meets the following criteria:

• • The taxpayer incurred or assumed the debt in connection with business property;
  • The taxpayer is not a C corporation;
  • The property is not a farm;
  • The debt was assumed or incurred before January 1, 1993, or the purpose of the debt is “to acquire, construct, reconstruct, or substantially improve” the property; and
  • The taxpayer elects to have the debt treated as QRPBI.

The amount of the QRPBI exclusion is subject to limits based on the property’s net fair market value and the amount of depreciable real property that the taxpayer owns. These limits prevent taxpayers from using the QRPBI exclusion to create new equity in real property.

Deemed Exchange

Modifying the terms of a loan can lead to tax liability if it results in a reduced amount of debt. A significant modification of a debt instrument could be deemed an exchange of the existing debt instrument for a new one. If the issue price of the “new” instrument is lower than that of the original one, the IRS could consider the difference to be debt forgiveness income.

Tax Consequences When a Property Owner Disposes of a Distressed Property

The key tax considerations when disposing of distressed property are:

• • Whether the owner recognizes a gain or loss;
  • Whether the lender forgives debt that remains unpaid after the sale; and
  • Whether the lender has further recourse after forgiving the debt.

Sale of Property

When a distressed property owner sells the property to pay off the debt — often known as a “fire sale” — the same basic rules for calculating gain or loss apply as in other real property sales:

• • If the sale price is greater than the property’s adjusted basis, the difference is a taxable gain.
  • If the adjusted basis is more than the sale price, the owner has a loss.

The lender may choose to forgive debt that remains after the sale of the property. The tax treatment of the debt forgiveness depends on the nature of the loan:

• • Forgiveness of recourse debt is considered regular taxable income.
  • Forgiveness of nonrecourse debt is taxed as a gain.

Surrender of Property

The IRS views disposing of a distressed property through a deed in lieu of foreclosure as a sale. The sales price is the property’s fair market value. The same rules apply as above regarding gains vs. losses and recourse vs. nonrecourse debt.

If you have any questions or would like additional information, please contact me.

Contributing Author: Nicholas L. Shires, CPA, is the partner-in-charge of tax services at Dannible & McKee. Nick has over 20 years of experience providing tax and consulting services to a wide range of clients, including individuals and privately held companies. For more information on this topic, you may contact Nick at nshires@dmcpas.com or (315) 472-9127.