The pandemic’s financial ripple effect has been particularly hard on commercial real estate. Facing shortfalls in revenue, tenants in the hospitality and retail sectors have fallen behind on leases, sharply curtailing cash flows for their landlords, who have been experiencing difficulty staying up to date on their loans.
Amid the downturn in consumer spending, retail has been hardest hit, with delinquency rates of nearly 23%; hospitality, hampered by sharp declines in travel, is tracking at 15% according to Trepp CMBS Research. By comparison, multifamily, office and industrial properties have been less severely affected, keeping their delinquencies below 3.5%.
When financial conditions are adverse, commercial lenders may be willing to renegotiate existing loan agreements, in some cases, forgiving a portion of an outstanding loan in exchange for other concessions.
Everything in real estate is negotiable. Many lenders are willing to forgive the remaining debt on short sales involving commercial properties, vacation homes, and multi-unit buildings. The decision of whether to forgive the debt or pursue the seller for a deficiency judgment is up to the lender.
If the bank believes that the seller is destitute, then it does not make good business sense for them to spend thousands of dollars trying to collect money from someone who does not have it.
The bigger issue for a short sale seller of a commercial property, second home, or investment building may be the tax consequence of the forgiven debt. If a lender does forgive thousands of dollars of mortgage debt, they will issue a 1099C to the borrower.
That is also reported to the Internal Revenue Service. The IRS treats forgiven debt in these circumstances as if it is ordinary income.
If a business owner has $200,000 of debt forgiven on a commercial building, then that owner will probably be liable for paying income tax on that $200,000. If the phantom income, as it is called, is not offset by losses or expenses, then there will be a hefty tax due.
$200,000 of added income in a 25 percent tax bracket means that the person could owe $50,000 to the IRS. Anyone considering a short sale should consult with their advisors about the potential tax consequences.
