Nicholas L. Shires, CPAThe commercial real estate market has been rough for some time, and the residential market has seen wild fluctuations. Inflation, high interest rates and decreased demand for office space have contributed to these trends. One result is a rise in the number of distressed properties, especiallycommercial office properties.
When a property becomes “distressed,” it typically means the owner is facing financial difficulties and cannot continue to make payments to the lender or pay property taxes. This can lead to foreclosure, short sales or bankruptcy, all of which have potential tax implications. Understanding what to expect from the IRS and knowing the options for dealing with a distressed property are crucial.
Options for Owners of Distressed Property
Distressed property owners may have several options for dealing with their situations. They may want to keep the property while restructuring the debt, or they might be willing to part with the property if it means satisfying the lender.
Scenarios in which a distressed property owner keeps the property include negotiating the following with their lender:
- Reducing the principal loan amount and resuming payments;
- Settling on a lower payoff amount; or
- Modifying other loan terms, such as reducing the interest rate or making interest-only payments for a limited time.
The owner might have the following options for disposing of the property:
- Selling it to pay off the loan;
- Surrendering it to the lender through a deed in lieu of foreclosure; or
- Allowing it to go into foreclosure.
Not all of these options will be available to every property owner. The available options and ideal course of action will depend on factors like the nature of the debt, the debt amount, the property’s value, the owner’s tax basis and whether the owner is solvent. If the owner is insolvent, their options may depend on whether they have already filed for bankruptcy.
Dealing With Distressed Properties Tax Implications and IRS Involvement
Short Sale: In a short sale, the property is sold for less than the remaining mortgage balance. While this may help you avoid foreclosure, the forgiven debt could be considered taxable incomedepending on the nature of the loan, resulting in a higher tax bill unless you qualify for an exclusion under the Mortgage Forgiveness Debt Relief Act.
Deed in Lieu of Foreclosure: This involves voluntarily transferring ownership of the property to the lender to satisfy the mortgage debt. The IRS views this as a sale and may treat the forgiven debt as taxable income, similar to a short sale.
Foreclosure: If the property goes into foreclosure, the forgiven debt might result in taxableincome known as Cancellation of Debt Income (CODI). Certain exclusions, such as insolvency, might reduce or eliminate this tax liability.
Loan Modification: If you negotiate with your lender to modify the terms of your mortgage, such as reducing the principal balance, the IRS could consider this as debt forgiveness incomewhich might be taxable. However, this option could help you retain ownership of the property.
Proactive Steps and Final Considerations
To manage the potential tax consequences of distressed properties, owners should take proactive measures. This includes maintaining accurate financial records, seeking expert tax advice early on, and exploring all possible avenues to restructure or settle their debts. Being informed and prepared can help mitigate the impact of IRS involvement and support better decision-making during difficult times.
Nicholas L. Shires, CPA, is the partner-in-charge of tax services at Dannible & McKee, LLP, a public accounting firm headquartered in Syracuse, New York. For more information on this topicfeel free to contact Nick at (315) 472-9127 or nshires@dmcpas.com. To find out more about Dannible & McKee, visit www.dmcpas.com.
