Commercial Mortgage Loan Workouts – Part Three – Discounted Payoffs and Borrower’s Discounted Purchase of the Mortgage Loan

In a discounted payoff (DPO), the lender releases the borrower, guarantor and the property in return for payment of an amount that is less than the outstanding balance of the mortgage loan. Economically equivalent to a DPO is the borrower’s purchase of its own mortgage loan from the lender at a discount. A DPO as well as a borrower’s discounted purchase of the mortgage loan both avoid (or at least reduce) all four of the harms threatened by a foreclosure. First, unlike in a foreclosure, these transactions enable the borrower to retain ownership of the mortgaged property. Second, since the lender is giving up all of its rights under the loan, neither the borrower nor the guarantor is subject to liability for any deficiency as may be the case with a foreclosure. Third, while these transactions may damage the borrower’s credit, the impact will not be nearly as severe as that of a foreclosure.

Finally, unlike a foreclosure, these transaction structures will often enable the borrower to avoid the current realization of taxable income. If the borrower or related party purchases its own mortgage debt at a discount or the lender forgives all or a portion of the borrower’s mortgage debt, the borrower will realize cancellation of debt income (CODI) equal to the amount of the discount or the amount of the forgiveness, as applicable[1]. However, if the borrower is not a C corporation and the mortgage debt constitutes “qualified real property business indebtedness”, then the borrower may elect to exclude such CODI from gross income by reducing the basis of certain of the borrower’s depreciable property. This right is subject to certain limitations.

A loan constitutes “qualified real property business indebtedness” if and only if:

(1)  the loan was incurred or assumed by the taxpayer and is secured by real property;

(2)  such real property is used in a trade or business;

(3) the loan was incurred or assumed before January 1, 1993 or the loan was used to acquire, construct, reconstruct or substantially improve the real property[3]; and

(4) the taxpayer timely makes an election under IRC Section 108(c).

As to the third requirement, if a loan satisfies such requirement, then any refinancing of such loan will also satisfy the third requirement to the extent the refinanced amount does not exceed the balance of the original loan at the time of refinancing.[4] Consequently, if a loan with an unpaid balance of $10 million was originally used to acquire the real property and such loan was refinanced for a new loan of $11 million, then $10 million of the refinancing would be considered acquisition financing and would satisfy the third requirement. As to the fourth requirement, the required election “must be made on the timely-filed (including extensions) Federal income tax return for the taxable year in which” the qualified real property business indebtedness was discharged or partially discharged.[5] Thus, if a taxpayer purchased its own qualified real property business indebtedness at a discount in 2023, its election under IRC Section 108(c) would have to be included in its timely filed 2023 Federal income tax return.

Limitations

The right to exclude forgiven qualified real property business indebtedness from gross income is subject to two limitations. First, the amount excluded from gross income cannot exceed the excess of the outstanding principal loan balance immediately before the discharge over the net fair market value of the real property immediately before the discharge.[6] For this purpose, the net fair market value of the real property is its fair market value reduced by the principal balance of any debt secured by such property (other than the loan being discharged or partially discharged).[7]

Second, the amount excluded from gross income cannot exceed the aggregate adjusted bases of all depreciable real property held by the taxpayer immediately before the discharge reduced by depreciation deductions for the year in which the discharge occurred.[8]

Basis Reduction

The amount of forgiven qualified real property business indebtedness that is excluded from gross income under IRC Section 108(a)(1)(D) must be applied to reduce the basis of the taxpayer’s depreciable real property. The taxpayer must reduce the adjusted basis of the real property encumbered by the qualified real property business indebtedness before reducing the adjusted bases of other depreciable real property.[9] The taxpayer’s other depreciable real property includes the taxpayer’s proportionate interest in depreciable real property held by a partnership in which the taxpayer is a partner.[10]

Example

Consider the following example. Taxpayer (T), an individual, owns a multi-tenant commercial building worth $1 million that is encumbered by a mortgage loan with an unpaid balance of $1.5 million. The proceeds of the mortgage loan were used to acquire the property. T’s adjusted tax basis in the property is $800,000. When the mortgage loan goes into default, the lender offers it for sale at an auction and T buys it for $900,000. As a result, T realizes $600,000 in CODI which is the difference between the unpaid balance of the mortgage loan ($1.5 million) and its purchase price ($900,000). However, since the mortgage loan was used to acquire the property and is secured by the property, the mortgage loan constitutes qualified real property business indebtedness so long as T makes a timely election under IRC Section 108(c). As a result, T is permitted to exclude from gross income that portion of the total forgiven amount ($600,000) that does not exceed the difference between the outstanding principal loan balance immediately before the sale ($1.5 million) and the net fair market value of the property immediately before the sale ($1 million). Accordingly, T is entitled to exclude $500,000 of the forgiven amount from gross income and must recognize ordinary income in the amount of $100,000, which is the balance of the $600,000 forgiven amount after subtracting the $500,000 exclusion. T also must reduce his tax basis in the property by the $500,000 exclusion. Therefore, T’s adjusted basis in the property is reduced from $800,000 to $300,000.

[1] I.R.C. §§ 61(11) and 108(e)(4); Treas. Reg. § 1.61-12(c)(2)(ii).

[2] I.R.C. §§ 108(a)(1)(D) and 108(c).

[3] I.R.C. §§ 108(c)(3)(B) and 108(c)(4).

[4] I.R.C. § 108(c)(3).

[5] Treas. Reg. § 1.108-5.

[6] I.R.C. § 108(c)(2)(A); Treas. Reg. § 1.108-6(a).

[7] Treas. Reg. § 1.108-6(a).

[8] I.R.C. § 108(c)(2)(B); Treas. Reg. § 1.108-6(b).

[9] Treas. Reg. § 1.1017-1(c).

[10] I.R.C. § 1017(a)(3)(C). However, in order to make a basis reduction in the taxpayer’s share of partnership depreciable real property, the partnership must consent to a corresponding reduction in the partnership's basis in such property with respect to such partner. Treas. Reg. § 1.1017-1(g)(2). Such reduction applies only to such partner and not to the “common basis of partnership property”. Treas. Reg. § 1.1017-1(g)(2)(v).