In the normal world of commerce, “COD” means you GET something of value when you pay “cash on delivery”. As is often the case, the Internal Revenue Service has given a new meaning to “COD”. In their lexicon, COD means you pay them cash when you GIVE up something.
If you are the owner of commercial real estate financing with recourse debt and the value of the property is less than the mortgage amount, brace yourself for an introduction to the IRS version of COD. In the situation when the value of your property is less than the mortgage amount and you don’t have enough cash flow to pay the current principal and interest when due, you have four “traditional” options and one contrarian option.
First, you can raise new capital to subsidize the mortgage payments or to pay down the loan to a level that is serviced from the current cash flow. The obvious peril, in this case, is that you may be throwing good money after bad. If the value of the property is more than 20% below the mortgage amount, it may be a very long time before the cash flow grows sufficiently to bring the property value back even with the mortgage amount. This option is less attractive given that in many markets values on certain commercial property types have declined 40% or more and rents are flat or declining while most expenses are rising. Add to that fact pattern the reality that in order to refinance your property at maturity the property will need to be valued at 125 – 135% of the maturing mortgage amount, and you really have to challenge whether it makes sense to pour more money down a rat hole.
Second, if your lender is enlightened about the reality of property values and the length of time it is likely to take for property values to recover, you may be able to convince your lender to “write down” the loan amount. This is when you need to know all about the IRS version of COD, which is “cancellation of debt”. Whether your mortgage is recourse or non-recourse, the amount by which the loan is written down results in ordinary income to the owners. There are certain exceptions, such as bankruptcy and insolvency, to the current recognition of COD income. However, if the property is owned by a pass-through entity, such as a partnership or limited liability company, the exceptions for bankruptcy or insolvency are applied at the partner or member level.
Third, you can capitulate to foreclosure or do a voluntary deed-in-lieu (“DIL”) of foreclosure. In the common vernacular, you just hand the keys to the lender. However, the pain is not over and the IRS will be standing at the exit door to collect taxes on the COD and, in many cases, gain on the sale. If the property was financed with recourse debt, the measure of the COD is the difference between the fair market value of the property and the debt balance. In addition, since a foreclosure or DIL is treated for tax purposes as a sale of the property, in the case of property financed with recourse debt you will have a gain equal to the difference between the fair market value of the property and the adjusted tax basis of the property. In the case of property financed with non-recourse debt, foreclosure is treated for tax purposes as a sale of the property for an amount equal to the debt amount and you will have taxable gain equal to the difference between the debt balance and the adjusted tax basis of the property/
Fourth, the entity owning the property, either a partnership or limited liability company in most cases, may file a petition under Chapter 11 of the U.S. Bankruptcy Code. Debt canceled in a Chapter 11 reorganization case is not included in your income if the debtor is under the jurisdiction of the court and the cancellation of debt is granted by the court or occurs as a result of a plan approved by the court. For individual partners or LLC members, the bankruptcy exception to the recognition of COD applies at the partner or member level. Accordingly, if the partnership files for bankruptcy protection and achieves cancellation of debt under the supervision of the bankruptcy, the COD income will still be included in the ordinary income of the partner or member unless the partner or member is insolvent or has filed a petition under Chapter 11. Given the cots of prosecuting a case in the Bankruptcy Court, the stigma associated with bankruptcy filings, and the fact that the individual partners or members may still recognize ordinary income, the bankruptcy option may not be the best alternative.
Given the unattractive consequences of these traditional options to resolving distressed commercial real estate, a distressed borrower must ask what other options are available. There is at least one contrarian firm, Abacus Financial, LLC, that offers a compelling contrarian option. Abacus seeks to acquire well-located commercial real estate at a price greater than the debt encumbering the property, regardless of the value of the underlying collateral. The silver lining for the distressed borrowers is that they are relieved of dealing with the day-to-day harassment by lenders, unpaid vendors, and disgruntled investors AND they accomplish a sale at above-market prices while realizing capital gains, rather than ordinary income.
Before making any decision about how to resolve your distressed commercial real estate you should consult your attorneys and tax advisors and make a “reality check” on when you think the property may recover sufficient value to enable you to refinance without writing a huge check to your lender.