“Qualified real estate debt”
While the insolvency exception is passed on to the partner in many cases, taxpayers, with the exception of C corporations, have the option to exclude cash on delivery income derived from “qualified commercial real estate debt” at the legal entity level. This exception applies only to debts arising from and secured by real estate used in trade or business. For partnerships, unreported legal entities and grantor trusts, income exclusions and elections are recorded at the partner level. Conversely, the determination of whether the debt is qualified debt of the real estate business is determined at the partnership level.
For a debt to be considered qualified real estate debt, the following criteria must be met:
• Real estate must be owned by the partnership in connection with trade or business carried out by the partnership.
A triple net lease lease cannot be considered a trade or a business.
• The debt has arisen or was expected for the acquisition, construction, reconstruction or significant improvement of real estate.
• Affiliate must promptly select a personal income tax return by completing Form 982.
The amount of cash on delivery income from the qualified debt of the real estate business is determined at the partnership level. It is limited to the excess of the principal amount outstanding immediately before maturity over the fair market value of the immovable property, reduced by the principal amount outstanding of any other qualifying commercial liability for immovable property secured by such property. After determining the amount, the choice is made by completing Form 982 with the partner’s income tax return, combined with a decrease in the basis for the partner’s participation in the partnership by the amount of cash-on-delivery income excluded, as well as by reducing the basis for real estate on the tax return for the next year.
When foreclosure is applied, whether voluntarily (instead of him) or compulsorily, the creditor obtains ownership of the collateral to pay off the outstanding debt. A transaction is usually considered a sale of property, but the tax treatment also depends on whether the debt is recourse or non-recourse.
When a non-recourse debt is foreclosed, the outstanding principal balance canceled is included in the proceeds from the sale of the property. Profit or loss is defined as gain or loss under Section 1231 for commercial property subject to amortization reimbursement or capital gains for investment property. Income may also be subject to Section 1250’s depreciation recovery rules. The fair market value of a property does not affect the amount realized for income tax purposes.
Likewise, when it comes to recourse debt, the same rules generally apply, unless the recourse debt exceeds the FMV of the surrendered property. In this case, the transaction is considered to be two unrelated transactions in which the taxpayer may be required to recognize ordinary income and capital gains or losses. First, the taxpayer recognizes the income as cash on delivery to the extent that the canceled debt exceeds the FMV of the property at the time of foreclosure. Second, the sale or exchange is considered to have taken place, and the profit or loss will be determined by calculating the difference between the amount realized (debt canceled minus the cash on delivery portion) and the property’s adjusted tax base. In situations where the FMV of a property is less than its adjusted tax base, the taxpayer could experience a capital loss (a normal loss if the Section 1231 property was used as collateral) and a cash on delivery gain on the same transaction. This would result in a net effect of the same total gain or loss as if the property were secured by non-recourse debt.
There are several strategies for restructuring, changing or eliminating liabilities that can mitigate the adverse effects of federal and state income taxes related to cash on delivery, depending on individual facts and circumstances.
We are here to work with you to find the best approach for you and your business. Contact your Citrin Cooperman Specialist today to find out more.
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