Restructuring Mortgage Debt? Watch Out For COD Income – Landlord & Tenant – Leases


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In tough economic times, real estate owners and investors often
work with their lenders to restructure mortgage debt. Lenders may
be willing to reduce the interest rate, extend the repayment term
or even forgive a portion of the debt. These modifications can
provide welcome financial relief, but it is important to understand
the tax implications. Any time a lender reduces your principal
balance, lowers your interest payments or gives you more time to
pay, you may have cancellation of debt (COD) income, which is
reportable as ordinary income on your tax return.

Not every modification of a mortgage loan triggers COD income,
however. There are a number of exceptions and exclusions that may
allow you to avoid or defer COD income. For purposes of this
discussion, several exclusions may be relevant:

  • Debts discharged in bankruptcy;

  • Debts canceled when the taxpayer is insolvent. COD income is
    excluded only to the extent of your insolvency — that is, the
    amount by which your liabilities exceed the fair market value of
    your assets (Note: For partnerships, COD income is passed through
    to the individual partners, so whether the insolvency exclusion
    applies depends on each partner’s financial situation);

  • Cancellation of qualified real property business indebtedness
    (see below); and

  • Cancellation of qualified principal residence indebtedness (see
    below).

QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS

You may elect to exclude COD income (subject to certain limits)
for debt that is incurred or assumed in connection with, and
secured by, real estate used in a trade or business. In addition,
debt incurred or assumed after 1992 must be used to acquire,
construct, or substantially improve the property. Real estate used
in a trade or business generally includes rental real estate, but
not real estate held for sale (Note: For some real estate —
such as properties subject to a triple-net-lease — it may be
difficult to ascertain whether they are used in a trade or business
or are ineligible investment properties.) A separate exclusion is
available for qualified farm indebtedness.

QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS

Through the end of 2025, homeowners may exclude up to $750,000
in COD income ($375,000 for married couples filing separately) in
connection with a mortgage used to buy, build or substantially
improve their principal residence. The debt must be secured by the
residence. This exclusion also applies to debt used to refinance
such a mortgage, up to the amount of the original mortgage
principal immediately before the refinancing.

REQUIREMENT TO REDUCE TAX ATTRIBUTES

Generally, the exclusions discussed above allow you to defer the
tax rather than avoid it permanently. When you exclude COD income,
you are required to reduce certain tax attributes (but not below
zero), potentially increasing your tax liability in future years.
For example, if you exclude COD income related to qualified real
property business indebtedness, you must reduce the tax basis of
depreciable property by the amount excluded. Similarly, if you
exclude COD income related to qualified principal residence
indebtedness, and you continue to live in the home, you must reduce
its basis. If you take advantage of the bankruptcy or insolvency
exclusions, you’ll need to reduce one or more tax attributes,
such as net operating losses, certain tax credits, capital loss
carryovers, or the basis of certain properties.

The rules regarding application of the various exclusions and
reduction of tax attributes are quite complex, particularly for
real estate owned by partnerships. If you have restructured
mortgage debt or plan to in the near future, please contact us to
discuss your tax-planning options.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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