The economic impact of the global COVID-19 pandemic is likely to result in a considerable number of defaults, adjustments and debt restructuring of borrowers. An often overlooked but important consequence of debt changes or settlement agreements are the significant tax issues that arise, many of which create abundant opportunities and potential pitfalls for borrowers. However, depending on how a debt modification or settlement is structured, and particularly whether the property that is the security for the debt is transferred to the lender, the tax consequences should be carefully considered and in some cases may be. considerably reduced.
One of the most important tax questions in a forbearance or debt settlement agreement is whether “debt forgiveness” occurs for income tax purposes. Debt cancellation occurs if a lender does not collect the amount that a borrower is required to pay. Additionally, when property is secured for debt, debt cancellation can occur through foreclosure, repossession, mortgage modification, voluntary transfer of ownership, or abandonment. Cancellation of debt income is taxed at the ordinary income rate while gains on the transfer of real estate are generally taxed at lower rates of appreciation, subject to the qualification of ordinary income for the recovery of the l ‘amortization.
When a lender cancels a borrower’s obligation to repay a debt, the borrower may be required to include the amount of that debt forgiven in their gross income for the year of the cancellation. For debts that are used to finance property, qualifying the debt as recourse debt and non-recourse debt, and whether ownership is transferred to the lender, will have a significant impact on the tax consequences. The following is a list of “debt forgiveness” threshold issues that lenders and borrowers should keep in mind when negotiating debt modification, forbearance, or settlement agreements.
TRANSFERS OF OWNERSHIP TO LENDER
The threshold tax question is whether the financed asset is transferred by the borrower to the lender in full or partial debt settlement. In the case of a transfer of property to the lender in debt settlement, such as a deed in lieu of foreclosure, Section 1001 of the Internal Revenue Code of 1986, as amended (Code), and the Regulations Treasury issued under Section 1001 of the Code states that the transfer is treated as a sale of the property by the borrower to the lender. How the sale is taxed depends on whether the debt is recourse or non-recourse, the fair market value (FMV) of the transferred property, the extent to which the debt is discharged as a result of the transfer, and the payment. tax base in the property.
Debt is treated as “recourse” debt for tax purposes when the borrower is personally responsible for paying the debt, even if the amount of debt exceeds the FMV of the debt. The amount realized on the transfer of goods that are the subject of a claim with recourse is the FMV of the property. For tax purposes, the amount of debt in excess of the FMV of the property will constitute the write-off of debt income and should be included in the borrower’s gross income, subject to certain exclusions. Under these tax rules, transfers of goods subject to a claim with recourse result in the transfer being split into two parts. First, there is the forgiveness of debt income (taxed at the ordinary income rate) when the amount of recourse debt is greater than the FMV of the transferred property. Second, there is a gain or loss on the sale of the property depending on the difference between the FMV of the property and the tax base of the property. As noted above, the sale generally results in a capital gain (or loss), subject to the depreciation recapture rules.
If non-recourse debt is used to finance real estate, the tax treatment is very different. Debt is treated as “non-recourse” for tax purposes when the borrower is not personally responsible for paying the debt and the lender’s only collection option is against the financed property, and not against the other assets of the debtor. the borrower. The amount realized on the transfer of goods subject to a non-recourse debt is the amount of debt and no part of the potential gain is treated as debt income write-off. This means that the transfer of a property to a lender subject to non-recourse debt does not trigger ordinary income under the debt cancellation tax rules whereas an identical property subject to recourse debt may, in fact, be subject to recourse debt. depending on the FMV of the property and the amount of debt, trigger ordinary income under the cancellation of debt tax rules.
NON-TRANSFER OF OWNERSHIP TO THE LENDER
If the debt reduction does not involve the transfer of the asset to the lender, a debt reduction can result in the cancellation of the debt income owed to the borrower. In this case, borrowers should consider the various exceptions to revenue recognition under Article 108 of the Code. The tax treatment of debt forgiveness under Article 108 of the Code depends on many factors, such as the tax classification of the borrower (for example, partnership, limited liability company (LLC) taxed as a partnership, sole member LLC or S corporation) and if the borrower is insolvent or is subject to bankruptcy proceedings. The rules in Section 108 of the Code are complicated and should be carefully discussed with the borrower’s tax advisers.
DECLARATION OF THE TRANSACTION FOR TAX PURPOSES
How each party will handle the transaction for tax purposes and whether a party will report any debt income write-offs to the Internal Revenue Service (IRS) must be specifically and clearly stated in each agreement that reduces or eliminates the debt. Some courts have held that a silent agreement regarding tax consequences allows the lender to determine how to report the transaction to the IRS. Therefore, where possible, an agreement should explicitly state how the lender will report the cancellation of debt income on IRS Form 1099-C (Debt Cancellation) or IRS Form 1099-A (Acquisition or Surrender of Debt. guaranteed property), as the case may be. As noted above, the tax classification of debt as recourse or non-recourse affects the cancellation of the debt issuance and the tax return should be consistent with the underlying tax classification.
If a debt is written off, canceled or discharged, it is important to recognize and understand this technical area of tax law. In order to avoid unfavorable tax results in these situations, it is imperative to analyze the tax consequences of the structure of the transaction and its impact on the cancellation of debt income.