Inflation has since cooled since its peak of 9.1% in June 2022. However, sustained higher interest rates and the popularity of remote work has posed significant challenges to the real estate industry, particularly commercial real estate in urban areas. These factors, coupled with higher inflation, have increased operating costs and debt service payments while decreasing real estate cash flows and property values.
Higher running costs, higher debt service, and lower property values have made refinancing mature debt increasingly difficult for real estate owners. As a result, increased foreclosures and heightened debt workouts are predicted. In this environment, real estate lenders and borrowers must prepare for a wave of debt maturity, with $929 billion in commercial real estate debt due this year. Consequently, tax practitioners are tasked with advising both borrowers and lenders on how to navigate potential tax complications.
Borrowers are encouraged to avoid transactions that will result in cancellation of indebtedness income, or CODI. Essentially, CODI is the tax term for income realized by a borrower when all or part of their debt is either cancelled or is considered cancelled for tax purposes. Borrowers generally aim to avoid CODI since, unless an exception applies, they will incur taxable income without actual cash from the transaction to cover the resultant income tax.
Consequently, tax advisers have a crucial role in helping manage this situation. They can assist by ensuring that neither the existing nor the new debt is treated as publicly traded, as it is more likely a borrower will incur CODI under such conditions. Furthermore, advisers can negotiate changes to maturity dates and interest rates rather than principal amounts. This can prevent the deemed exchange from resulting in CODI.
Approximately $929 billion of commercial real estate debt is predicted to mature in 2024, according to the Mortgage Bankers Association. Both borrowers and lenders will need to consider the tax consequences of debt forgiveness or modification if borrowers are unable to fully repay or refinance this debt.
The article is authored by Craig Stern, a managing director at Mazars USA with extensive experience in real estate, investments, and transaction service.