Don’t Turn Your Loan Problem into a Tax Problem

Although the Federal Reserve recently cut the federal funds rate to between 3.5 percent and 3.75 percent, the lowest in three years, the future landscape of commercial real estate remains uncertain.

Reports indicate increased activity in the office market heading into 2026, but the stark decline in property values highlighted by such recent activity cannot be ignored. An office tower in Denver recently sold for $5.3 million, down from its $176 million purchase price in 2013.

While many lenders have granted generous extensions on outstanding loans, the prospects of refinancing many projects are low, given the plummeting valuations.

But debtors exploring their options in connection with an underperforming mortgaged property should be aware of the possible tax implications of such a decision. A deed in lieu of foreclosure may be a valuable option for a debtor, but it is essential to understand how the IRS will view such a transaction and debtor’s potential tax liability.

How Does the IRS View Your Loan?

A deed in lieu of foreclosure is an arrangement that allows a debtor to cancel its loan obligations in exchange for handing back the keys by conveying the mortgaged property to the lender.

If a debtor is unable to pay debt service and perform other loan obligations, this option gives debtor an opportunity to wipe the slate clean and avoid a costly and time-consuming foreclosure proceeding.

As an alternative to a deed in lieu transaction, a lender may ask debtor to sell the property in a short sale transaction in which the proceeds from the sale are less than the outstanding debt. A short sale may be more advantageous for the lender since the borrower may be able receive a higher purchase price for the distressed property than the lender could obtain by taking possession of the property through foreclosure or a deed in lieu of foreclosure.

In either situation, lender will be viewed as having forgiven a portion of the debt (and for purposes of this article, the discussion about deed in lieu transactions applies equally to short sale transactions).

IRS treatment of such forgiveness depends on whether the IRS views the loan as recourse or non-recourse against the debtor.

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