Cancellation of nonrecourse debt.

It's not uncommon for a taxpayer that has defaulted on a debt to find the property securing the debt is worth less than the amount of the liability. In the event of a sale, the tax treatment will differ depending on how the debt is structured. If the debt is "recourse," a sale of the property results in a gain equal to the difference between the value of the property and its basis. A taxpayer would have cancellation-of-debt (COD) income equal to the difference between the recourse debt and the value of the property. If the debt is "nonrecourse," the full amount of the debt is included in the sale proceeds, resulting in gain on the sale and no COD income. Since an insolvent taxpayer can exclude COD income, tax-payers frequently try to avoid sale treatment when disposing of property securing nonrecourse debt so they can report COD income.

A partnership, 2925 Briarpark, Ltd., borrowed approximately $25,600,000 in a nonrecourse loan secured by real property. Its basis in the property was approximately $11,100,000. The partnership was in default on the note. The creditor concluded it would get the largest recovery if the property was sold for its fair market value. The creditor agreed to allow Briarpark to sell the property and to cancel the note if Briarpark transferred the net sales proceeds to the creditor.

Briarpark round a purchaser willing to pay $11,600,000 for the property if all debts and liens were cancelled. The partnership sold the property and transferred approximately $10,936,000 of net proceeds and $177,500 in cash reserves to the creditor, who cancelled the nonrecourse debt. Briarpark treated these events as two separate transactions, reporting a $61,000 loss on the sale of the property and $14,470,000 of COD income as a result of the creditor's cancellation of the nonrecourse debt. The IRS reclassified the transaction as a single event--a sale resulting in a $14,400,000 gain ($26,000,000 amount realized minus $11,600,000 of basis plus expenses). Briarpark appealed.

Result. For the IRS. Briarpark argued that the sale was separate from the debt cancellation because it involved a separate purchaser and took place before the cancellation. The partnership believed this entitled them to treat the cancellation as having created COD income rather than gain. The Fifth Circuit Court of Appeals ruled there was only one transaction. The fact that the creditor agreed to cancel the note on receipt of the net sale proceeds and that the buyer insisted all liens be canceled indicated the transactions were the same as a foreclosure sale. The Fifth Circuit rejected the taxpayer's reliance on Gershkowitz, a case in which the debt was forgiven independent of, and three months before, the sale of the property. In Briarpark, the sale was part of the debt cancellation transaction.

It is possible for cancellation of nonrecourse debt to create COD income. The taxpayer is responsible for showing that the cancellation was in no way related to a disposition of the property. A taxpayer who fails in this burden will have taxable gain rather than excludable COD income.

* 2925 Briarpark, Ltd. v. Comm., 163 F.3d 313, 99-1 USTC [paragraph] 50,209, CA-5.