Taxation of Canceled Real Property Indebtedness

5/17/2017 | Articles & Alerts

In this economic downturn, many developers borrowed substantial debt to finance projects that commenced during the real estate boom. Many of these projects have been stalled.  As a result, numerous developers have been unable to meet their debt obligations.  In many cases, developers have been saddled with properties worth less than the mortgage indebtedness.  Some lenders have been working with developers to restructure debt and in some instances cancel debt.  Such cancellation of debt can leave developers with unintended tax consequences.

Generally, if you are indebted to someone and they cancel that debt in full or in part, you are treated as having income and you may have to pay tax on this income. In the case of developers, this income is treated as ordinary. You can, however, elect to exclude canceled “qualified real property indebtedness” from income.

“Qualified real property indebtedness” is, generally, debt that meets all of the following conditions: (i) it was incurred or assumed in connection with real property used in a trade or business; (ii) it is secured by real property; (iii) it was incurred or assumed after 1992, if the debt is either qualified acquisition indebtedness, defined below, or debt incurred to refinance real property business debt incurred or assumed before 1993, but only to the extent that the amount of such debt does not exceed the amount of debt being refinanced; and (iv) you elect to apply these rules by filing Form 982 with your federal income tax return.

“Qualified acquisition indebtedness” is either (i) debt incurred or assumed to acquire, construct reconstruct, or substantially improve real property that is used in a trade or business and secures the debt, or (ii) debt resulting from the refinancing of qualified acquisition indebtedness, to the extent that the amount of the debt does not exceed the amount of the debt being refinanced.

The amount of debt you can exclude from income is limited to the excess, if any, of the outstanding principal amount of the qualified real property business indebtedness immediately before the cancellation, over the fair market value, immediately before the cancellation of a mortgage securing the debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by that property immediately before the cancellation.

In addition to this limit, the amount of canceled qualified real property business debt you can exclude from income cannot exceed the total adjusted bases of depreciable property you held immediately before the cancellation of the qualified real property business indebtedness, other than depreciable real property acquired in contemplation of the cancellation. In figuring this overall limit, you use the adjusted basis of property after any reduction in basis because of the exclusion of debt from income canceled, generally under the bankruptcy or insolvency exclusion.

This exclusion does not apply to cancellation of debt in a title 11 bankruptcy case or to the extent you were insolvent immediately before the cancellation.