Tax Consequences of Mortgage Discharge
No one plans on foreclosure or bankruptcy, but your clients facing either should weigh the tax treatment of discharged debt.
by Michael Smith, et al./Journal of Accountancy
In the current real estate climate of decreased property values and excess inventories, many rental property owners are facing reduced cash flows due to vacancies. At the same time, the fair market value of their property may be close to or even less than the amount owed on the mortgage ("upside down"). Thus, CPAs are commonly asked about the tax consequences if owners are no longer able to service debt on their property and lose it to the lender or substantially modify their debt.
These clients may also be interested in taking advantage of provisions of the American Recovery and Reinvestment Act of 2009 (ARRA) that allow them to defer recognition until 2014 of income from cancellation of indebtedness occurring in 2009 or 2010 and then recognize it ratably over a five-year period starting that year.
One typical situation involves a client (individual) who owns a membership interest in a limited liability company (LLC) that is treated as a partnership for tax purposes, which in turn holds title to real property. Let's assume the LLC also has a second, equal owner, with both owners having equal capital accounts and sharing profits and losses equally. The LLC is the legal titleholder of an office building with a mortgage of $21.5 million and a tax basis of $16.5 million. The property was refinanced two years ago when times were good, which allowed the members to each receive $1.5 million in distributions. The property is currently estimated to be worth $17 million. This client has heard that if the property is given back to the lender, the discharged debt will be ordinary income. He wants to confirm the tax consequences. How will a foreclosure, bankruptcy or debt restructuring affect this client?
In a foreclosure, the tax treatment depends on whether the debt secured by the property is nonrecourse or recourse. A debt is nonrecourse if the lender's only recourse upon the borrower's default on the debt is against the property securing the debt. A debt is recourse if the lender can look beyond the collateral pledged for the loan and hold the borrower — for a pass-through entity, its owners — personally accountable for the unpaid balance.
This article has been excerpted from the Journal of Accountancy. View the full article here.