Tax Considerations Relating to Debt for Distressed CRE Owners

By Michael Torhan

Negative cash flows, high vacancy rates, environmental and geographic concerns and other macroeconomic factors are all risks and, therefore, reasons why real estate owners may experience operating distress. Furthermore, real estate owners commonly finance the acquisition of properties with debt, which comes along with various debt covenants, restrictions and debt service requirements. As a result of a lack of viability for servicing debt and/or where the fair market value of real property decreases below the remaining balance of debt, real estate owners need to review potential options and outcomes, including the harsh potential of a foreclosure.

In addition to analyzing the economics of a distressed position, real estate owners must consider the tax implications of the various outcomes surrounding debt. In the worst-case scenario of a foreclosure, not only can an owner lose a property but also be subject to income tax on phantom income.

There are various outcomes relating to debt for a real estate owner in distress. A lender may agree to a reduction of the principal balance of the debt or alternatively allow a borrower to settle the debt at a discount. In other cases, a lender may allow for a debt workout whereby the terms of the debt are modified. In each of these first three scenarios, the real estate owner retains the property. In other scenarios, a real estate owner unfortunately loses the property. A real estate owner may look to sell the asset in a fire sale in order to satisfy the debt balance without going through a foreclosure transaction or alternatively may give up the property in a deed-in-lieu of foreclosure transaction. Ultimately, without a satisfactory negotiation result, a lender may foreclose on the loan and force a sale of the asset.

Each of the distress scenarios have tax implications that need to be considered and are discussed in the tables below, which separate the scenarios between when an owner is able to retain the real property versus when the real property is disposed of. Several key factors and definitions need to be understood prior to considering the tax implications of a given scenario:

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