Written by: David J. Cooper, CPA and Mark Ravera, CPA
Property owners and developers are facing growing financial pressure. Interest rates have more than doubled in recent years, operating costs continue to climb, and tenant demand remains inconsistent, especially for office and retail space. These conditions make it increasingly difficult to refinance maturing loans on workable terms.
Borrowers with previously low fixed-rate debt are now confronting higher payments, lower cash flow, and tighter lending standards. Sometimes, lenders are unwilling to refinance unless the property’s performance or equity position improves significantly.
For many real estate investors, these aren’t distant concerns—they’re current realities. Understanding your options when debt becomes unsustainable isn’t just helpful. Protecting your capital, managing tax exposure, and making confident decisions in uncertain conditions is essential.
Key Takeaways
- Market pressures are mounting: Rising interest rates, persistent vacancies, and refinancing uncertainty are straining real estate owners and developers.
- Not all debt is treated equally: Recourse and non-recourse debt follow different tax paths during restructuring, short sales, or foreclosures.
- Restructuring can trigger taxable income: Debt forgiveness often results in “cancellation of debt” (COD) income. However, exceptions like insolvency, bankruptcy, or qualified real property business indebtedness (QRPBI) election may apply.
- Each scenario carries different implications: From partial forgiveness to short sales and foreclosures, the structure of your debt and your solvency status determine your tax exposure.
- Early action matters: Financial distress usually surfaces in operational metrics months before it hits your financial statements. Engage with your CPA and lender early.
- This is not DIY territory: The tax outcomes are complex and deeply situational. If anything here sounds familiar, it’s time to call your advisory team.
What is Distressed Debt in Real Estate
Distressed debt refers to a loan obligation that a borrower struggles to meet. This could stem from:
- A balloon payment that can’t be refinanced under current market conditions.
- Buildings with persistent high vacancy or declining lease rates.
- Rising costs (interest rates, maintenance, insurance) that push cash flow into the red.
- Market shifts (e.g., lower post-2020 demand for office space) eroding property value below debt levels.
Distressed debt is not just about delinquency—it’s when servicing debt requires injecting personal or business capital to keep the project afloat.
What are the Early Warning Signs of Financial Distress?
Here are some signals to monitor:
- Multiple quarters of negative cash flow
- Debt service coverage ratio dropping below 1.0
- Sharp increases in tenant improvement costs without rent growth
- Deferred maintenance is piling up due to a lack of capital
- Declining occupancy rates outpacing market trends
For many owners, these red flags appear in financial statements 6–12 months before a crisis. Early recognition allows you to approach lenders from a position of strength, not desperation.
What are the three types of debt restructuring?
When debt becomes unserviceable, three common paths emerge:
1. Restructure with the Lender
You renegotiate terms (e.g., extend maturity, reduce principal). If any portion is forgiven, this typically triggers income. But you may qualify for relief:
- Insolvency exemption: If your liabilities exceed assets, forgiven debt may not be immediately taxable.
- Bankruptcy exclusion: COD income is not taxable if discharged in a Title 11 bankruptcy.
- QRPBI election: You can elect to reduce your basis in the property rather than recognize income.
2. Short Sale (Forgiveness on Sale)
You sell the property, and the lender forgives the shortfall between the sale price and the loan balance.
- Recourse debt may trigger ordinary COD income.
- Non-recourse debt typically results in capital gain or loss, not COD income.
3. Foreclosure or Deed-in-Lieu
The lender takes the property to satisfy the debt.
- With recourse debt, the difference between debt and fair market value may be taxable as ordinary income.
- With non-recourse debt, the entire debt is treated as the “amount realized,” triggering a potential capital gain.
What’s the Difference Between Recourse and Non-Recourse Debt?
Understanding this distinction is critical:
- Recourse debt allows the lender to pursue the borrower personally for unpaid balances.
- Non-recourse debt limits the lender’s claim to the collateral property only.
This difference affects how forgiveness is taxed and how foreclosures are treated. It’s not just a legal nuance—it shapes your tax outcome.
Talk with your advisor early.
Whether navigating a potential restructure, exploring a property sale, or anticipating a shortfall, knowing how your debt is structured—and what scenarios trigger different tax consequences—can help you make informed, proactive decisions. From assessing insolvency status to evaluating forgiveness income or basis reductions, your ability to act with clarity gives you leverage.
If any of this sounds familiar—or you’re trying to get ahead of a looming issue—contact our team. We help real estate developers understand the financial and tax consequences of restructuring decisions.