Real Estate Tax Planning for 2010: Dealing with Distressed Assets

By David Thaw, Gumbiner Savett Inc.:
There are a number of options when it comes to dealing with non-performing assets, and much of it depends on the status of the property. The loan may be heading for default or the owner may have already completed a workout with the lender. No matter what the action, it is prudent to consider the tax consequences to ensure that your choice provides the best outcome in the long run.

With the continued downturn in the real estate markets, the one topic that many will wrestle with at this time of year is their year-end tax strategy: What do we do with these distressed assets?

There are a number of options when it comes to dealing with non-performing assets, and much of it depends on the status of the property. The loan may be heading for default or the owner may have already completed a workout with the lender. No matter what the action, it is prudent to consider the tax consequences to ensure that your choice provides the best outcome in the long run.

Understanding the Options

Loan Modification: Modifying an existing loan is a viable option. However, the owner should carefully analyze the new loan terms such as: Has there been a reduction in the interest rate or principal? Are the changes to the payment terms or covenants? Are there security enhancements?

The Assessment: The first place to start is to review the modified loan terms against the “old’ loan terms to determine whether or not there is “cancellation of indebtedness” (COD) income. The tax law generally provides bright line tests in making this determination. If the owner were to recognize COD, the next question is whether the COD has to be included in the owner’s income.

There are many provisions which may allow the owner to exclude COD income from his tax return such as (but not limited to):

• Title 11 bankruptcy proceedings
• Insolvency
• Is it qualified real property business indebtedness?

In addition, the American Recovery & Reinvestment Act of 2009 allows taxpayers to elect to defer COD income from the reacquisition of a debt instrument in 2009 or 2010 and include such COD income in income ratably over a five year period, from 2014 through 2018.

Disposing the Asset

There is another option; dispose of the asset either through a voluntary conveyance to the lender or outright abandonment.

The Assessment: With a transfer of the property to the lender, it is essential to analyze the character of the debt as nonrecourse or recourse because the tax consequences can be quite different. A nonrecourse debt can only generate gain or loss from a sale or exchange of the property. A recourse debt can give rise in part to COD income and in part to gain or loss from a sale or exchange of the property. Consideration should be given to abandoning. The owner may be entitled to an ordinary deduction .

The bottom line is that with careful planning, property owners may be able to utilize the tax laws to lessen the blows arising from the ownership of distressed assets.