Cancellation of debt income (CODI)
from distressed properties is becoming more prevalent in today’s economy. The term CODI sounds discouraging;
however, there are a few opportunities to
minimize the current tax impact as a result
of debt forgiveness or debt restructuring.
As Jackie Matsumura of Burr Pilger
Mayer explains, “There are several ways to
deal with the inability to make loan repayments, including short sales, workouts,
foreclosure, abandonment, to name a few.”
But, she adds, “There are different tax and
nontax implications for each of them, and
dealing with distressed properties is definitely not something that owners want to
do alone.”
She recommends property owners seek
the advice of a tax professional before
making any decisions.
Smart Business discussed the tax implications of CODI with Matsumura to learn
more about them and the importance of
seeking tax advice early.
Is cancellation of debt income always taxable?
No, not always. CODI is generally taxable, but there is a provision in the tax law
which allows the exclusion of CODI from
taxable income. The provision applies to
individuals and businesses, and to name
some exceptions for real property owners
— let’s call them ‘taxpayers’ — who file
Chapter 11, who are insolvent, or who have
qualified real property indebtedness or
qualified principal residence indebtedness
qualify for the exclusion. In addition, there
are specific tax consequences as a result of
the exclusion; for example, net operating
losses are reduced by the exclusion
amount, tax credits are reduced, and/or the
tax basis in property is reduced.
Also, the determination of whether CODI
is taxable depends on the type of taxpayer,
meaning whether the taxpayer is an individual, corporation or a pass-through entity. In a partnership situation, the determination is not made at the partnership level,
but at the partner level. As a result, one
partner’s allocated CODI income may be
treated differently from another partner’s
because one may be insolvent but the
other may not, or one may file Chapter 11
but the other may not.
How can tax professionals help parties
involved in buying and selling distressed
properties get through the CODI maze?
Tax professionals can help taxpayers
deal with distressed properties on the front
end. Factors that affect tax results include
what type of property is held, whether it is
a principal residence, investment property
or real estate used in a business; how the
properly is held, say, by an individual, corporation or a partnership; what type of
loan is involved, whether it’s recourse or
nonrecourse; or if the taxpayer has other
businesses or has other unrelated tax
issues to consider. Their tax advisers can
assist in projecting out the tax implications
of restructuring debt, when combined with
other aspects of the taxpayer’s tax situation, or recommend the ideal timing of certain events to minimize taxes. Also, careful
planning is necessary because the character of income may differ between CODI
and loss from disposition of property (ordinary income versus capital loss).
Are laws regulating disposition of distressed
properties and CODI changing?
Yes. For example, Congress recently
enacted the Mortgage Forgiveness Debt
Relief Act of 2007, which allows homeowners to exclude up to $2 million of debt
that is forgiven through Dec. 31, 2009. One
thing to note, however, is that the amount
is not really tax-free, because the basis of
that property is reduced by whatever is
excluded from income; so it’s really a
deferral of tax.
Is it in lenders’ and owners’ best interests to
cancel debt tied to distressed properties?
That depends. It is generally a business
decision as to what the pros and cons of
cancelled debt are from both the lenders’
and taxpayers’ perspectives. Taxpayers try
restructuring the debt with lenders so that
they can keep their property and protect
their credit ratings. And, lenders do not
necessarily want to foreclose on distressed
property, sell it and get whatever they can
for it. That could be more costly than trying
to work out a deal with the taxpayers. Each
lender works with the taxpayer differently.
Some are willing to explore other options
and others are not, so the taxpayer may not
be able to control that decision.
Does anyone benefit from forgiving taxpayers’ debt on distressed properties?
A reduction in the amount of debt may
benefit both the taxpayer and the lender.
One scenario is where the lender works
with the taxpayer to reduce the balance of
the debt, but in exchange, receives a partial
interest in the ownership of the property or
the entity that owns the property. This way,
the taxpayer is able to keep the property
and the debt repayment is more manageable, and the lender would share in the
future profits generated from the property.
Since there are multiple scenarios with
different tax consequences, it is highly recommended that taxpayers seek counsel
very early in the process.
JACKIE MATSUMURA is a partner in the Tax Practice at Burr Pilger Mayer. Reach her at [email protected] or (925) 296-1035.
