As a general rule, prior to the 2009 Stimulus Bill, deemed taxable income called cancellation of indebtedness income (CODI) results when indebtedness is discharged for less than its face amount, when indebtedness is reduced as part of a consensual workout where the borrower retains the property that secured the debt, or when indebtedness is acquired at a discount by the borrower or by a person or entity that is related to the borrower. CODI can be a factor when a borrower negotiates or is forced to provide an equity interest (shares of stock or interests in a partnership or an LLC, for example) to a lender in satisfaction of all or a portion of indebtedness held by a lender or when the lender contributes indebtedness to the capital of the borrower. The potential for CODI is, also, present in connection with commercial foreclosures, friendly or otherwise, of recourse indebtedness.
When CODI is triggered on a real estate entity’s indebtedness, frequently, the ‘price-to-be-paid’ is a one dollar basis reduction in the taxpayer’s direct or indirect interests in depreciable real property for each and every dollar of CODI that has been excluded. This may be a significant number in commercial real estate investments at this time. A collateral consequence of this basis reduction is that most of the extra gain recognized when the property whose basis was reduced is sold often ends up being taxed as ordinary income like an accelerated depreciation fact situation.
The recently passed and signed 2009 economic stimulus adds a new elective CODI option for business indebtedness worked out, discharged, acquired by the borrower (or a related person); and exchanged by the lender for equity interests in the borrower or contributed by the lender to the capital of the borrower during calendar years 2009 or 2010. This could result from re-casting loan terms as part of a restructuring which is taking place on a daily basis in this troubled real estate and financial market.
Under the Stimulus Bill of 2009, the renegotiated loan terms could result in CODI that would otherwise have been recognized currently is now able to be deferred and recognized ratably over the 5-year period beginning roughly in 2014 and ending roughly in 2018. This affords some necessary breathing room for both borrower and lender; but may not be applicable in all fact situations that borrowers and lenders are working through in the current real estate market. Absent a loan renegotiation, an asset can be moving toward a 2009 version of the Bataan Death March for Real Estate assets which are underperforming or simple the borrower has been unable to secure acceptable financing and find themselves moving toward a commercial foreclosure in their jurisdiction.
Once the election is made under the new law for a particular discharge, the other potential exceptions (insolvency, bankruptcy, qualified real property business indebtedness, etc.) become unavailable for that discharge.
One final note for California taxpayers: The State of California doesn’t automatically incorporate Federal changes to the tax law. Therefore, these new Federal provisions will not apply to California income taxes until and unless the California legislature passes conforming tax legislation. As you know, it is a challenge to secure agreement on any tax-related matters in Sacramento.
Please consult your tax counsel and accounting professionals to review the best course of action based on your own specific circumstances.
CIRCULAR 230 DISCLOSURE: This communication is not a tax opinion. Pursuant to Internal Revenue Service regulations, to the extent that this contains tax advice, it is not intended or written to be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer or for promoting to another party any tax related matter addressed herein.