In today’s challenging real estate and construction landscape, many borrowers face pressure on loans tied to property development, investment, and rental operations. When the market shifts, property values fall, and cash flow dries up, it’s not uncommon to see workouts involving foreclosures, deed-in-lieu of foreclosure, loan modifications, or outright debt forgiveness. This article highlights key tax implications associated with various forms of construction and real estate loan restructuring and forgiveness.

Cancellation of Debt Income

One of the major tax risks in loan restructuring, forgiveness, and modifications is the emergence of “cancellation of debt” (COD) income. Generally speaking, when a lender forgives, cancels, or effectively reduces a borrower’s indebtedness, the borrower must recognize taxable income, even though no cash is received. Without proper planning, you may be hit with a significant tax bill, turning what was perceived to be a way out of debt into a potentially larger financial burden altogether.

Foreclosures / Deed-in-Lieu of Foreclosure

In situations involving foreclosure or deed-in-lieu of foreclosure, it’s imperative for the borrower to understand how the debt is being secured:

• If the loan is recourse (i.e., the borrower remains personally liable or the loan allows the lender to pursue other assets beyond the property), a foreclosure or deed-in-lieu may trigger COD income and a gain or loss on the disposition of the asset.
• If the debt is nonrecourse (i.e., the borrower’s liability is limited to the property itself), the foreclosure is treated more like a sale of the property, and generally no COD income arises. Instead, you would recognize a gain or loss on the “sale” of the property for tax purposes.

In short, even if a borrower proceeds with a foreclosure or provides a deed-in-lieu of foreclosure, they may still encounter unexpected tax consequences—including COD income or taxable gain on the property. For construction and real estate projects where property values have declined and debt levels are high, these outcomes often come as an unwelcome surprise to borrowers seeking relief.

Loan Modifications and Workouts—When They Become Taxable

Before outright foreclosure, many real estate and construction borrowers negotiate debt modifications (e.g., lower interest rate, extended term, principal reduction, property substitution, release of guarantor, change in collateral). These may feel like helpful solutions, but from a tax standpoint, they can be treated as a deemed exchange of debt, triggering COD income or other tax consequences.

There is a two-step analysis in determining if a deemed exchange has occurred:

1. Has there been a “modification” of the debt instrument (i.e., an alteration of rights or obligations)?
2. If so, is it a significant modification? If the change is economically meaningful (change in yield, timing of payments, collateral, or obligor, etc.), then the old loan is treated as extinguished, and a new loan is issued.

If the modification is significant, the borrower may be required to recognize COD income equal to the difference between the outstanding debt of the original debt instrument and the issue price of the new one.

For example, suppose a borrower has 5 years remaining on their loan with an 8% interest rate and an original principal balance of $10M. Due to difficulties with cash flow, the borrower requests relief from their lender. In response, the lender agrees to reduce the principal balance to $8M, drop the interest to 5%, and increase the life of the loan to 8 years.

Step 1: Was there a modification?

A modification includes any change in the legal rights or obligations, such as:

• Principal reduction
• Interest rate change
• Term extension

All the following apply in this case, so we move to Step 2.

Step 2: Was it a significant modification?

Under IRS Reg. § 1.1001-3, a modification is significant if it is economically meaningful, including:

• A change in the timing of payments
• A change in collateral or obligor
• A change in the principal amount

Since there was a change in the principal amount of the loan, this modification would be considered significant. Therefore, the old loan would be extinguished, and a new loan would be issued with the terms agreed upon in the modification.

As a result of the modifications, the borrower would need to recognize COD income equivalent to the change in principal balance ($10M – $8M = $2M of COD income). This income is usually taxable unless an exclusion applies (e.g., insolvency, bankruptcy, qualified real property business indebtedness).

What Borrowers Should Ask and Document

To manage risk and optimize tax outcomes, here are questions and documentation that you should consider:

• What are the exact terms of the loan (recourse vs. nonrecourse, guarantor obligations, collateral)?
• If you are considering a workout/modification: what terms are changing—interest rate, principal amount, payment schedule, maturity, collateral, or guarantors?
• Is the modification likely to be “significant” from a tax standpoint? (e.g., big change in yield or timing)
• If the debt is being forgiven (principal reduction) or substituted for property/asset, what is the fair market value of the property, and what is your tax basis?
• Are you in a real-property trade or business such that the real-property trade or business rules (QRPBD) exclusion might apply, or do you anticipate insolvency or bankruptcy?
• What tax attributes (loss carryforwards, credits, basis in property) do you have that could be impacted if COD exclusion is used?
• Are you documenting the transaction with the lender: the agreement, the terms of modification, and the fair-market-value analyses?
• Based on the outcome (foreclosure, deed-in-lieu, sale, modification), what is the realistic cash flow and tax liability? In many cases, the tax hits are “phantom” – you recognize income without receiving cash.

Key Considerations for Construction & Real Estate Borrowers

• If you are struggling to meet the obligation of your real estate or construction loan, don’t simply think of the lender workout as just a “deal.” The tax consequences can be significant.
• Foreclosures/deed-in-lieu and modifications both carry risk of taxable COD income or gain/loss recognition.
• If you qualify for the QRPBD exclusion or insolvency/bankruptcy relief, you may reduce or defer the tax burden—but you need to understand the trade-off (reduced tax attributes) and ensure you meet the requirements.
• Document everything carefully, understand recourse vs. nonrecourse distinctions, and assess your tax position early in the workout or sale process.

Navigating loan workouts, modifications, and potential forgiveness in the construction and real estate space can feel overwhelming, especially in periods of economic downturn. The earlier you involve a tax professional, the more options you have available to prevent costly surprises and structure a solution that protects both your project and your bottom line. If you’re facing financial pressure from lenders, are planning to restrict your debt, or simply want clarity around your tax exposure, our team is here to help. Please feel free to reach out to our tax professionals at (703) 385-8888 to discuss your situation, and be sure to follow our newsletter for the latest tax updates.