31.10 Restructuring Mortgage Debt

Rather than foreclose on a mortgage, a lender (mortgagee) may be willing to restructure the mortgage debt by cancelling either all or part of the debt. As a borrower (mortgagor), do not overlook the tax consequences of the new debt arrangement. If the lender agrees to a “workout,” under which part of your loan principal is reduced as part of a loan modification, or if you pay off the loan early in return for a “discount” that reduces the debt, and you keep the collateral, the reduction or discount is canceled debt, reportable as ordinary income (cancellation of debt income) unless an exception applies. This is true whether or not you are personally liable for the debt. However, if you were not personally liable (nonrecourse debt) and do not keep the collateral, there is no cancellation of debt income.

You may be able to avoid the ordinary income from the cancellation of the debt by taking advantage of one of the exclusions in the law, such as the exclusion for qualified principal residence indebtedness or the exclusions for insolvency, bankruptcy, qualified business real estate debt (see below), or qualified farm debt. Details of these exclusions are discussed in 11.8. The Jones example below illustrates the IRS approach to figuring insolvency upon a reduction of a nonrecourse debt.

In the case of partnership property, tax consequences of the restructuring of a third-party loan are determined at the partner level. This means that if you are a partner and are solvent (11.8), you may not avoid tax on the transaction, even if the partnership is insolvent.

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image Caution
Form 1099-C
If your lender agrees to a “workout” that reduces the principal balance of your loan, the cancelled debt will be reported on Form 1099-C in Box 2. This amount must be included in your income unless one of the exclusion rules (11.8) applies.
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EXAMPLE
In 2011, Jones borrowed $1,000,000 from Chester and signed a note payable for $1,000,000. Jones was not personally liable (nonrecourse) on the note, which was secured by an office building valued at $1,000,000 that he bought from Baker with the proceeds of Chester’s loan. In 2012, when the value of the building declined to $800,000, Chester agreed to reduce the principal of the loan to $825,000. At the time, Jones held other assets valued at $100,000 and owed another person $50,000. In 2012, Jones realizes income of $175,000 on the reduction of the debt, but he can avoid tax to the extent he is insolvent.
To determine the extent of Jones’s insolvency, the IRS compares Jones’s assets and liabilities immediately before the discharge. According to the IRS, his assets total $900,000: the building valued at $800,000 plus other assets of $100,000. His liabilities total $1,025,000: the debt of $50,000 plus the liability on the note, which the IRS considers to be $975,000, equal to the $800,000 value of the building and the $175,000 discharged debt. The difference between the assets of $900,000 and liabilities of $1,025,000 is $125,000, the amount by which Jones is insolvent. As Jones is insolvent by $125,000, only $50,000 of the $175,000 discharged debt is treated as taxable income.
Jones must claim the insolvency exception on Form 982 by checking the box on Line 1b and entering the excludable $125,000 on Line 2. In Part II of Form 982, Jones must reduce his “tax attributes,” such as the basis of his property. The $50,000 debt cancellation that is not excludable under the insolvency rule must be reported as ordinary income on Line 21 of Form 1040 (“Other income”).

Restructuring debt on business real estate.

A solvent taxpayer may avoid tax on a restructuring of qualifying business real estate debt (11.8) by electing to reduce the basis of depreciable real property by the amount of the tax-free debt discharge. The election to reduce basis is made on Form 982.

EXAMPLE
Grant, who is solvent, owns a building worth $150,000 used in his business. It is subject to a first mortgage of $110,000 and a second mortgage of $90,000. Grant’s basis in the building is $120,000. On July 12, 2012, the second mortgagee agrees to reduce the second mortgage to $30,000. This results in debt discharge of $60,000 ($90,000 − $30,000). The $60,000 is considered debt discharge income. But Grant may elect to exclude $50,000. He reports the remaining $10,000 of discharged debt as taxable income. The exclusion limit is the excess of the pre-discharge mortgage balance over the pre-discharge fair market value of the building, reduced by the other mortgage (11.8), calculated as follows:
2nd mortgage before discharge $90,000
  Less: Fair market value of building reduced by first mortgage ($150,000 − $110,000)   40,000
Excludable amount $50,000
On Form 982, Grant may elect to exclude $50,000 from income because the basis of the building is sufficient to absorb a basis reduction of $50,000.
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