Tax Deferral Options for Resulting Cancellation of Indebtedness Income
With many real property owners facing maturing debt situations and depressed property values, the tax consequences of cancellation of indebtedness income (COD) that might result from debt restructuring should be considered. The American Recovery and Reinvestment Act of 2009 (ARRA), amended Section 108 of the Internal Revenue Code (IRC) that deals with tax treatment of income from the discharge of indebtedness. IRC Section 108 now provides real property owners with two potential methods to defer the taxation of COD income resulting from the restructuring of indebtedness on real property.
The first option, as enacted under ARRA, allows at the election of the taxpayer, for COD income incurred during the 2009 or 2010 tax year to be deferred until the tax year 2014, or the earlier occurrence of an acceleration event (generally death, sale of assets or the business, or the sale or exchange or redemption of an interest in a pass-through entity). Beginning in 2014, the deferred COD income must then be recognized ratably by the taxpayer over the next five years.
The second option, which existed pre-ARRA, may allow for longer deferral of the COD income related to qualified real property. Under IRC Section 108(c), income resulting from the discharge of qualified real property business indebtedness will be applied to reduce the carrying basis of the property. This method will effectively defer the recognition of any COD income until the property is sold. With additional planning, a like-kind exchange could defer recognition of the COD income indefinitely.
With proper planning, the tax cost of COD income related to restructuring of real property debt can be effectively deferred until the sale of the property, or to a time where economic conditions and cash flow improve.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.