Accounting Considerations for Debt Restructuring for Real Estate Owners

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The commercial real estate industry, particularly in the office space category, has endured a period of challenges since the COVID-19 pandemic. Increasing vacancies and falling lease prices in many markets, combined with climbing interest rates, have created an unstable environment for obtaining lending. As pre-pandemic commercial real estate debt has matured, some lenders have shown a willingness to work with owners on amendments and extensions to their debt facilities. Such amendments and extensions can bring financial stability to a real estate investment but come with accounting implications that should be considered for both income tax and U.S. Generally Accepted Accounting Principles (GAAP) reporting.

Tax Reporting Considerations

IRC Section 108(c) Debt Forgiveness

A taxpayer realizes cancellation-of-debt (COD) income when all or a portion of the taxpayer’s debt is discharged. COD income is generally taxable under IRC Section 61 even though there is no cash receipt.

IRC Section 108(c) allows COD income on real property business debt to be excluded from taxable income. In order to be eligible for this exclusion, the debt must be qualified real property business indebtedness (QRPBI). QRPBI refers to indebtedness incurred or assumed by a taxpayer in connection with real property used in a trade or business, or in connection with acquiring, constructing, or substantially improving such property. Taxpayers should carefully examine the changes to debt terms and determine whether the real property meets the definition of QRPBI.

The amount of QRPBI COD income exclusion reduces the basis of the depreciable real property of the taxpayer under IRC Section 1017. Basis reduction takes place in the taxable year following the year when debt discharge occurs. As such, real properties disposed of during the taxable year of the discharge are not subject to basis reduction.

Partnership Cancellation-of-Debt Income

When applying IRC Sections 108 and 1017 to businesses formed as partnerships, including LLCs taxed as partnerships, a partner’s distributive share of the partnership’s COD income is attributable to a discharged indebtedness determined in accordance with the partner’s interest in that partnership. Provisions under IRC Section 108(c) are applied at the partner level and not at the partnership level.

A partner may elect to reduce its proportionate share of the partnership’s basis in depreciable real property, provided that the partnership consents to adjust the partner’s share of inside basis. The election is made on a partner-by-partner basis.  Once a partner makes the election, its share of depreciation expense corresponds to the basis reduction. In other words, an electing partner’s distributive share of depreciation expense is reduced in the year following the debt discharge. Provisions under IRC Section 108(c) are means for electing partners to defer their share of COD income over the remaining life of the partnership’s real property instead of recognizing all of it in the year of discharge.

U.S. GAAP Reporting Considerations

Debt Modification, Extinguishment, and Troubled Debt Restructuring

Borrowers need to consider the guidance in ASC 470-50, Debt — Modifications and Extinguishments, and ASC 470-60, Debt — Troubled Debt Restructurings by Debtors, to determine whether a change to an existing debt instrument represents a debt modification or a debt extinguishment, or a troubled debt restructuring (TDR), all of which have different accounting and reporting implications.

An entity may modify the terms of its outstanding debt by restructuring its terms or by exchanging one debt instrument for another. When assessing the proper treatment, an entity first needs to consider whether the modification qualifies as a TDR. A modification is treated as a TDR if both of the following criteria are met: (a) the borrower is experiencing financial difficulty, and (b) the lender grants the borrower a concession, meaning the effective borrowing rate of the restructured debt is less than the effective borrowing rate of the original debt. If an entity has determined that a modification meets the criteria of a TDR, it could result in a restructuring gain or an adjustment to the interest expense over the remainder of the loan period.

If the criteria for a TDR are not met, the entity needs to assess whether the transaction should be accounted for as (a) the extinguishment of the existing debt and the issuance of new debt, or (b) a modification of the existing debt, depending on the extent of the changes. In order to determine the appropriate accounting treatment of the debt restructuring, a number of factors need to be considered, including whether a debt instrument was fully repaid with debt proceeds from a new lender, or if the terms of the debt were modified with the same lender, comparing the present value of cash flows under the original and modified instrument. At a high level, in a debt extinguishment, the original debt and related issuance costs are derecognized and the new debt and related issuance costs recorded, with any difference resulting in a gain or loss recognized in the income statement. In a debt modification, any new fees paid to the existing lender are capitalized, the effective interest rate is recalculated based upon the modified terms of the debt instrument, with no gain or loss recognized at the time of modification.

Other Reporting Considerations

An amendment to a debt instrument can also trigger a number of other reporting considerations. An entity should consider whether this is indicative of potential impairment of the underlying real estate asset. This would involve assessing whether estimated undiscounted future cash flows exceed the carrying value of the asset. As part of this analysis and a potential TDR, an entity should also consider whether there is substantial doubt about the entity’s ability to continue as a going concern. These analyses can be complex and result in substantial additional disclosures to your financial statements.

Conclusion

Debt restructurings are part of the investment life cycle of a real estate asset. Recent events have complicated this process as lower-rate debt facilities reach maturity in a higher-rate environment, which can lead to reporting complexities for both tax and U.S. GAAP reporting.

Contact Us

PKF O’Connor Davies is here to help you navigate and evaluate a debt restructuring for your commercial real estate property. If you have any questions, please contact your client service team or:

Matthew R. Jones, CPA
Partner
mrjones@pkfod.com

Nicole Ng, CPA
Director
nng@pkfod.com

Erjola Cufe, CPA
Manager
ecufe@pkfod.com