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  • Writer's pictureDr. Mark Lee Levine, Professor

Foreclosures and Discharge of Debt - Generating Taxable Income

The Current Setting: Debt is Coming Due:

Whether one would argue that the economy is doing “fine” or it is heading for a crash—soft or hard in nature, what cannot be challenged is the fact that a good deal of debt on commercial properties is coming due in the very near future.(1) In one recent article by Neil Callanan of Bloomberg, the author noted, along with many other reports, that the amount due on commercial loans in the current and next 2 years is in the range of $1.5 trillion dollars.(2)

With this huge debt coming due on commercial properties, what does this mean? If history is any indicator of what will develop, the clear answer is that such due dates create a rush for refinancing of the loans in question. This is the norm. However, what is not the norm is the inability to refinance the loans. Such status results when lenders are not able or are not willing to extend or grant the new loans that are needed under terms that existed the last time the loans were renewed or when the loan was first granted.

Discharge of Debt Creates Income Tax Issues

The discharge of debt has important tax ramifications. In general, the discharge of debt may cause the generation of taxable income to the person or entity that is relieved of the debt—or part of it—in question. This is under well-established Federal tax law.(3) Under Code Section 61,(4) Congress provided for many items that can constitute gross income. Under Code Section 61 (a) (11), the Code states that gross income includes (unless otherwise provided in the Code) “Income from the discharge of indebtedness.”(5)

More Defaults Can Produce More Taxable Income:

With more loans coming due where the debt cannot be reasonably refinanced, there will be more defaults on loans.

When the property securing the loan is transferred to the creditor, be it by foreclosure or a deed in lieu of the foreclosure, such transfer, discharging debt, can generate taxable income where the adjusted basis of the property is less than the current value of the property or its debt. (Whether “current value” or “debt” is involved depends on additional issues.)

By Professor Mark Lee Levine

PS With more office building refinancing issues, look for more defaults.

For a more detailed discussion of these issues, a possible higher tax rate applied, and considerations to avoid the taxable income in this setting, see the new article by Levine in the coming Levine Newsletter. (There is no charge for the Newsletter. See )

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1 Comment

Dec 03, 2023

On the subject of discharge of debt, it gets worse. The borrower's basis after depreciation is seldom considered when seeking relief from a bank, and is especially high with hotels in particular due to the acceleration of depreciating FF&E. Developers typically don't even consider the financial consequences after exiting a deal and the bankers, even if aware of the issue, don't broach the subject because it would mean a smaller settlement from the principals and/or guarantors. So developers have a bigger gain than what is refected in the debt forgiven, they have to add to that amount all of the depreciation they have enjoyed during their ownership. Of note, while banks are required to report debt forgiven and do,…

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