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Tax implications of restructuring debt.

Despite the relatively robust pace of economic expansion in the last half of 1992, when the economy grew at annual rate of 4.1%, the road to recovery for commercial real estate apparently is still a long one. While the numbers have improved, debt restructuring in the commercial real estate industry will continue to be a fact of life for both borrowers and lenders.

Commercial real estate in the New York suburbs, which was on the "go-go" track during the 1980's, has been particularly hit hard. For example, northern New Jersey's fourth quarter 1992 vacancy rate of 25.5 percent in its non-central business district was third highest among all 15 East Coast real estate markets; Central Jersey was fourth on the list at 20.4 percent. The rate was a whopping 28.1 percent in the central business district of Westchester County, the highest among all similar areas in the Northeast.

Though new construction in suburban areas has been drastically curtailed, going from a high of 103.8 million square feet nationally in 1986 to just 9.4 million last year, outdated commercial space and over-built areas at the core of the glut may be the last to recover.

What are the tax consequences for borrowers, such as commercial property owners, developers and land investors that are forced to restructure their debt?

Three common methods used to restructure debt between lenders and borrowers are: 1) terms of the loan are modified; 2) lender forgives all or a portion of loan; and 3) foreclosure or voluntary conveyance. The tax consequences of these alternatives are discussed below.

Loan Modifications

If the changes in the terms of a loan -- such as payment schedules, stated interest rate or principal amounts -- are "material" then the old loan is treated as having been exchanged for a new loan. This may result in cancellation of debt which is viewed under the tax laws as taxable income.

However, this income is realized only in cases in which the issue price of the new loan is less than the principal of the old loan. The issue price of a loan for tax purposes depends on prevailing interest rates and repayment schedules and may not equal the stated principal of the new loan. Your accountant should be consulted on this.

Forgiveness of Debt

Lenders may chose a second debt restructuring option: to forgive all or a portion of the loan. In general, if the principal of a loan is either erased or just reduced by the lender, the borrower must recognize taxable income from the discharge of indebtedness equal to the reduction in the amount of the borrower's indebtedness.

Foreclosure or Voluntary Conveyance

The tax effect of a foreclosure or voluntary conveyance to the creditor depends on whether the debt is recourse or non-recourse. Recourse debt means that the debtor is personally liable for the balance of any debt amount that remains after the creditor has taken possession of the property that secured the original debt.

Non-recourse debt means that the creditor can only use the property securing the loan to recoup the outstanding loan balance. As a result, the debtor's other assets are not reachable by the creditor.

In a foreclosure, if the debt is recourse, the debtor is treated as having sold the property for its fair market value. Gain or loss is measured by how much the fair market value of the property exceeds or falls short of its tax basis, which is customarily determined by original cost less depreciation. If the creditor cancels any remaining loan balance and does not hold the debtor liable for it, this will be cancellation-of-debt income to the debtor.

If the debt is non-recourse, the debtor recognizes a gain or loss which is measured by how much the total outstanding loan balance exceeds or falls short of the property's tax basis. This differs significantly from the recourse debt situation where gain or loss is measured by the property's fair market value. No cancellation-of-debt income is realized which might quality for the exclusions discussed below. Nevertheless, your accountant can advise you on how to possibly restructure a non-recourse foreclosure so as to allow at least a portion of income to be excluded.

Exceptions to Cancellation of Debt Income

The tax law provides certain exceptions to recognizing income from cancellation of debt. Common exceptions are:

1. Insolvency - No cancellation of debt income is recognized to the extent a debtor is insolvent. Insolvency is measured by the excess of debt owed over the fair market value of assets available to pay the debt.

2. Bankruptcy - A debtor who is discharged from the obligation to pay the loan either by order of a bankruptcy court or under a plan approved by the court is not liable for cancellation of debt income.

3. Purchase Price Adjustment - A reduction of seller financed purchase money debt does not result in cancellation-of-debt income. Instead, the reduction acts to reduce the tax basis of the property held by the debtor/buyer.

For both regular and S-corporations, the insolvency and bankruptcy exceptions are applied at the level of the entity itself. However, for partnerships, the exceptions are applied at the partner level. Partnerships, therefore, have to be especially cautious in debt restructuring situations because solvent and non-bankrupt partners will remain taxable on any cancellation-of-debt income.

Reduction of Tax Attributes

If cancellation-of-debt income is excluded from taxation, then starting in the year after the cancellation occurred the debtor must reduce any remaining tax loss carryovers, tax credits and the tax cost of depreciable property to the extent of the excluded income.

Many companies in the real estate industries continue to feel the effects of overbuilding in the 1980's followed by more recent corporate contractions. As these companies continue to "wait out" the recession, debt restructuring and its tax implications will continue to be important.
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Title Annotation:Insider Outlook; evaluation of debt restructuring in commercial real estate industry, including loan modification, forgiveness of debt and foreclosure or voluntary conveyance
Author:Hawkins, John (English admiral)
Publication:Real Estate Weekly
Article Type:Column
Date:Jul 21, 1993
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