Bloomberg reports that the office-property slump is producing losses for investors in commercial mortgage-backed securities, the investments backed by…

Bloomberg reports that the office-property slump is producing losses for investors in commercial mortgage-backed securities, the investments backed by pools of property loans. A family that owns an office building faces decisions too. Put in more cash, negotiate with the lender or give up the property?

The tax result depends on the loan documents and the depreciation schedule. Giving the building back can produce taxable income even when the owner receives no cash and loses the entire original investment.

Consider a building bought for $10 million with $2 million of equity and $8 million of debt. Over time, depreciation reduces its tax basis to $5 million. The debt is still $8 million, but the building is now worth $6 million. The owner gives it to the lender in full satisfaction of the loan and receives no cash.

If the debt is nonrecourse, meaning the lender can collect only against the property, the entire $8 million debt goes into the amount realized. Subtract the $5 million basis and the owner has a $3 million gain. The $2 million of original equity is gone, and there is a tax bill.

The tax calculation reflects deductions taken along the way. Depreciation generated deductions in earlier years and reduced basis too. The property's decline from its purchase price does not put that basis back.

Now use the same numbers with recourse debt, where the borrower is personally liable. A transfer of the $6 million property produces a $1 million property gain against its $5 million basis. If the lender forgives the remaining $2 million of debt, that produces $2 million of cancellation-of-debt income. We have arrived at the same total through two different tax calculations.

That distinction matters because §108 provides exclusions for canceled debt, including bankruptcy and insolvency, and an election for qualifying real-property business debt. Those rules do not simply exclude the property gain. Excluding canceled debt can also require giving up deductions or reducing asset basis.

For a partnership, the bankruptcy and insolvency exclusions are tested at the partner level. An LLC with an underwater building may have owners who are quite solvent. The fact that the property cannot pay its bills does not answer whether its owners can exclude the canceled debt.

And a lower appraisal by itself does not give the owner a deductible loss. The tax law generally requires a completed transaction or another event establishing that the loss has actually occurred.

Before anyone contributes more capital, the family needs the tax calculation for a negotiated sale, a loan workout and a surrender. There may be no cash coming back under any of them. The amount the family still has to pay can be very different.

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