Basis reduction due to discharge of indebtedness: proposed regs.

On Jan. 7, 1997, the IRS issued proposed regulations under Sec. 1017, specifying the manner and timing of reductions to asset basis accompanying the exclusion of discharge of indebtedness (COD) income from gross income; specific rules for applying Sec. 1017 to partnerships are also provided. The regulations are proposed to be effective on or after the date final regulations are published.

Background

Sec. 108(a) generally excludes COD income from gross income if:

* The debtor taxpayer is in a Title 11 case (bankruptcy);

* The debtor taxpayer is insolvent (to the extent of insolvency);

* The discharged debt is qualified farm indebtedness (QFI); or

* In the case of a taxpayer other than a C corporation, the discharged debt is qualified real property business indebtedness (QRPBI).

However, the mere exclusion of COD income is not the final consequence. If COD income is excluded from gross income due to bankruptcy, insolvency or QFI exceptions, Sec. 108(b)(2) requires a reduction of the debtor's tax attributes in the following order: (1) net operating losses (NOLs); (2) general business credits; (3) minimum tax credits; (4) capital loss carryovers; (5) basis in assets; (6) passive activity losses and credit carryovers; and (7) foreign tax credit carryovers. If the excluded COD income exceeds these attributes, the excess can be excluded from gross income without further consequences. If COD income is excluded from gross income due to the QRPBI exception, Sec. 108(c) requires only a reduction in the basis of the taxpayer's depreciable real property. Sec. 108(c) also provides for limitations on the QRPBI exception, which may result in all or a portion of the COD income being included in the taxpayer's gross income.

If basis is reduced pursuant to Sec. 108(b)(2)(E), Sec. 1017 governs the timing of the reductions. That section provides that basis reductions generally apply to properties held by the taxpayer at the beginning of the tax year following the tax year in which the discharge occurs. The proposed regulations focus on category 5 above (basis in assets), specify the properties whose bases are to be reduced and provide rules governing the amount of these basis reductions. Although the proposed regulations retain the general basis reduction rules set forth in regulations issued in 1956, they modify the prior rules in the interest of simplification and provide additional rules that reflect 40 years of statutory developments.

General Rules

Prop. Regs. Sec. 1.1017-1(a) provides that, for basis reductions required by the bankruptcy or insolvency exceptions, the reduction of basis of specified assets must be made in the following order (in proportion to adjusted basis):

1. Real property used in a trade or business or held for investment (other than real property included as inventory or held primarily for sale to customers in the ordinary course of business) that secured the discharged debt immediately before the discharge.

2. Personal property used in a trade or business or held for investment (other than inventory, accounts receivable and notes receivable) that secured the discharged debt immediately before the discharge.

3. Other property used in a trade or business or held for investment, other than inventory, accounts receivable, notes receivable and real property included as inventory or held primarily for sale to customers in the ordinary course of business.

4. Inventory, accounts receivable and real property included as inventory or held primarily for sale to customers in the ordinary course of business.

5. Property neither used in a trade or business nor held for investment.

Prop. Regs. Sec. 1.1017-1(e) also provides that a debtor may elect to treat real property included as inventory or held primarily for sale to customers in the ordinary course of business as depreciable property for purposes of the Sec. 108(b)(5) election, to reduce depreciable basis prior to applying the Sec. 108(b)(2) attribute reduction rules and the QFI attribute reduction rules. This election is not available for the QRPBI exception. In addition, Prop. Regs. Sec. 1.1017-1(d) provides an anti-abuse rule under which changes to property securing indebtedness are disregarded, if a principal purpose of the change is to affect Sec. 1017 basis reductions.

Multiple Debt Discharges

Prop. Regs. Sec. 1.1017-1(b)(2) provides that, if the COD income is attributable to the discharge of more than one debt, the basis reductions described will be applied in proportion to the COD income attributable to each discharged debt.

Example: A debtor excludes $100 of COD income from gross income ($20 from a secured debt + $80 from an unsecured debt); $40 of COD income (i.e., 40% of the COD income) results in the reduction of NOLs, general business credits, minimum tax credits and capital loss carryovers. The debtor must apply the basis reduction rules to COD income of $12 of secured debt (60% of the $20 secured debt) and $48 of unsecured debt (60% of the $80 unsecured debt).

Sec. 108(b)(5) and (c)

The ordering rules also apply, with appropriate modifications, to basis reductions under Sec. 108(b)(5) and (c). If a taxpayer elects under Sec. 108(b)(5) to reduce depreciable basis prior to reducing attributes under Sec. 108(b), only the basis of depreciable property will be reduced pursuant to the election. If the excluded COD income exceeds the basis reductions made under the Sec. 108(b)(5) election, the excess must be applied to reduce attributes according to the general Sec. 108(b) ordering rules. If the taxpayer elects to reduce basis due to the cancellation of QRPBI, only the basis of qualifying real property may be reduced. In addition, for basis reductions under Sec. 108(c), a taxpayer must reduce the adjusted basis of the "qualifying real property" to the extent of the discharged QRPBI, before reducing the adjusted basis of other depreciable real property. "Qualifying real property" is defined as real property with respect to which the indebtedness is QRPBI within the meaning of Sec. 108(c)(3).

Sec. 1017(b)(2) limits the basis reductions allowed under Sec. 108(b). Basis reductions shall not exceed the excess of the aggregate basis of property held by the taxpayer immediately after the discharge over the liabilities of the taxpayer immediately after-the discharge. This limitation does not apply I to reductions of basis by reason of a Sec. 108(b)(5) election. Prop. Regs. Sec. 1.1017-1(c) modifies the limitation to reflect any basis reductions made under a Sec. 108(b)(5) election. Thus, if the basis of a debtor's assets is reduced by $100 via a Sec. 108(b)(5) election, the aggregate asset basis of the debtor, for limitation purposes, will be reduced by $100.

Partnership Rules

Sec. 1017(b)(3)(C) provides that a partnership interest is treated as depreciable property for purposes of the Sec. 108(b)(5) election (and as depreciable real property for Sec. 108(c) purposes) to the extent of the partner's proportionate interest in the partnership's depreciable property (or depreciable real property). This rule may only be applied if there is a corresponding reduction in the basis of the partnership's depreciable property ("inside basis"). Prop. Regs. Sec. 1.1017-1(f) generally allows the partner to choose whether to ask the partnership to reduce the partner's share of depreciable partnership property, and also generally allows the partnership the right to grant or deny the request in its sole discretion. However, a partner is required to ask the partnership to reduce basis in its depreciable assets if the partner owns (directly or indirectly) a greater-than-50% capital and profits interest of the partnership, or if the partner receives a distributive share of COD income from the partnership. The partnership must consent to reduce a partner's share of inside basis if consent is requested by partners owning (directly or indirectly) an aggregate of more-than-50% interests in the partnership's capital and profits. Prop Regs. Sec. 1.1017-1(f)(2) (iii) also requires a "consenting" partnership to provide the partners with a "Partnership Consent Statement" on or before the date the partnership files its Form 1065, and requires the partner to attach a copy of the statement to its Federal income tax return for the tax year in which the taxpayer has COD income excluded from gross income under Sec. 108(a).

From Robert Liquerman, J.D., LL.M., Washington, D.C.