Tax consequences of refinancing COVID-era debt
- Refinancing COVID-era debt at higher market rates can reduce cash flow, but it does not automatically create cancellation of debt income.
- Debt modifications, discounted payoffs and below-market restructuring terms can trigger tax consequences that require careful analysis.
- COD exclusions may offer relief, but they often come with trade-offs, including reductions to tax attributes.
- Borrowers should evaluate refinancing and restructuring options early to model tax impact, investor economics and potential alternatives before maturity.
Many real estate ventures and operating businesses financed or refinanced debt during the COVID-19 period when rates were unusually low. Now, as those loans mature and come to term, they are often facing materially higher borrowing costs and at the same time, insurance, payroll, repairs and other operating expenses have also increased.
The practical result is straightforward: More cash flow must be devoted to debt service, leaving less cash available for distributions to owners and investors. In some cases, sponsors may need to reduce projected returns or defer current payment of preferred returns.
Additionally, for some projects, returns have not yet provided the stabilization they anticipated, and the project’s fair market value may be less than its debt.
The key point is that a refinancing driven by market rates is not automatically a tax event. But in distressed situations, debt modifications, discounted payoffs and changes to investor economics can raise important tax issues.
When refinancing debt can create COD income
Cancellation of debt (COD) income generally arises when a borrower is relieved of an obligation to repay debt for less than the amount owed. In a simple refinancing, however, the borrower usually remains fully liable for the principal; the debt is simply replaced with new debt carrying a higher interest rate and perhaps different covenants or amortization terms.
That means refinancing at market terms generally does not create COD income merely because the new loan is more expensive. If a borrower pays off a maturing low-rate COVID-era loan in full with proceeds of a new third-party loan and there is no principal reduction or lender discount, there is generally no discharge of debt.
Economically, the borrower is worse off because debt service is higher, but tax law generally does not treat that fact alone as income.
The analysis becomes more nuanced when an existing lender modifies the old note rather than replacing it, because tax rules treat a significant modification as a deemed exchange of the old debt for new debt, which may cause a taxable event. Whether a modification is “significant” depends on whether the legal rights and obligations are altered in an economically meaningful way. Specifically, the rules test changes in yield, timing of payments, obligor or collateral and the nature of the instrument.
For example, a change in yield is generally significant if it exceeds the greater of 25 basis points or 5% of the annual yield on the unmodified debt. Likewise, a substantial deferral of scheduled payments can be significant; the regulations include a safe harbor under which deferrals are generally not treated as material if the deferred payments must be made by the end of the lesser of five years or 50% of the original term of the instrument. So, if a borrower not only accepts a materially different rate but also extends maturity or pushes out required payments, the debtor should consider whether the deal has crossed into significant modification territory.
Even then, a significant modification does not always mean COD income. The deemed exchange creates COD only if the issue price of the new debt is less than the adjusted issue price or principal amount of the old debt. In many debt workouts, if the modified debt bears interest at least equal to the applicable federal rate, the new debt’s issue price may equal its stated principal amount, which can prevent COD even though a taxable deemed exchange has occurred.
The classic COD case is a discounted payoff. Suppose a borrower owes $450,000 on a low-rate mortgage, and the lender agrees to accept $400,000 in full satisfaction if the borrower refinances with a new lender. The $50,000 reduction is generally COD income.
Another risk area is a significant modification in which the revised debt has a below-AFR rate. In that case, the issue price of the new debt may be based on the imputed principal amount rather than the stated principal and the gap between the old debt balance and the new debt’s issue price can produce COD income. In other words, the borrower may not see an explicit principal reduction in the documents, yet still have COD because the tax law revalues the modified obligation.
By contrast, a straightforward refinancing into a new 5- to 10-year loan at a higher market rate, with no principal reduction and no unusual below-market terms, is typically the easiest case: Painful economically, but generally not COD-producing.
If COD income does arise, the tax rules provide several important exclusions. The most familiar are for debt discharged in a Title 11 bankruptcy case and for debt discharged when the taxpayer is insolvent, to the extent of that insolvency. Real estate borrowers should also consider the exclusion for qualified real property business indebtedness and purchase-money debt adjustments may, in some cases, be treated as basis reductions rather than COD income.
These exclusions are helpful, but they are not free. Excluding COD generally requires the reduction of tax attributes such as net operating losses, capital loss carryovers and certain tax credit attributes.
In partnerships, another important point is that bankruptcy, insolvency determinations and qualified real property indebtedness elections are generally made at the partner level, not the partnership level. The partnership may report the COD item, but each partner separately determines whether an exclusion is available.
It is also important to remember that partnership debt reductions can affect outside basis, while separately stated COD income and exclusions flow through to the partners.
Structuring options for real estate debt refinancing
Perhaps, instead of just accepting the COD income, if there is enough time ahead of the refinance/maturity date, there are solutions that could be valuable in offering investors and owners a safer path.
In the past few years, taxpayers have begun to pivot their ownership structures to accommodate market volatility. By doing so, they have been able to leverage better debt terms and more favorable investor returns than if they stayed with the previous structure.
REIT advantages
Contributing appreciated real estate to a larger fund or REIT, often through an UPREIT structure, can provide access to more favorable debt terms because the property becomes part of a larger, more diversified real estate portfolio with greater access to capital.
Unlike an individual property owner, a REIT may have investment-grade credit, a diversified tenant base, increased liquidity and established relationships with institutional lenders. As a result, the REIT is often able to borrow at lower interest rates, obtain longer loan maturities and negotiate more flexible financing terms than would be available on a standalone property. In many cases, the REIT can refinance existing property-level debt with lower-cost corporate financing, reducing interest expenses and increasing cash flow available to investors.
From a tax perspective, debt must be carefully considered when contributing property to a UPREIT/Fund. If the contributed property is encumbered by debt, the contributor’s share of partnership liabilities and any debt relief resulting from the transaction must be analyzed.
However, when properly structured, an UPREIT and fund transaction can allow a property owner to defer gain recognition while obtaining the economic benefits of ownership in a larger platform that may have significantly more favorable financing options than those available to the owner on a standalone basis.
For other taxpayers, it may make more sense to sell the property now rather than incur additional fees to refinance the project into an unsustainable debt position. In short, refinancing low-rate COVID-era debt into today’s higher-rate environment often creates more economic pain than immediate tax pain. But once the transaction includes discounts, restructurings or investor-payment changes, borrowers should move quickly from cash-flow analysis to debt-modification and partnership-tax analysis.
How Wipfli can help
If you’re weighing refinancing options or evaluating the tax impact of a debt restructuring, Wipfli specialists can help you assess potential outcomes and identify planning opportunities before you move forward. Connect with our team to learn more and discuss your next step.
