Clarification of debt relief after the RRA.

The tax effects of debt relief can vary, depending on the nature of the debt and the structure of the transaction relieving the debt. For example, a foreclosure may have different tax ramifications than a sale by the debtor with the cash proceeds being paid to the lender to satisfy the debt. In light of the different tax consequences of debt forgiveness, it may be possible to structure debt relief transactions to minimize current and future tax liabilities.

Qualified real property business indebtedness

The Revenue Reconciliation Act of 1993 (RRA) amended Sec. 108(a)(1)(D) and (c) to allow non-C corporation taxpayers to exclude from gross income any debt relief income from "qualified real property business indebtedness," and to instead reduce the basis of the underlying real property. The amount excluded under this rule is limited to the excess of --the debt's outstanding principal amount, over --the fair market value (FMV) of the property involved minus any other "qualified real property business indebtedness" secured by the property.

The amount excluded cannot exceed the aggregate adjusted tax basis of depreciable real property held by the taxpayer immediately preceding the discharge, but after the reduction in tax basis under Sec. 108(b) and (g) (reduction in basis due to Title 11, insolvency and/or qualified farm indebtedness debt relief).

The basis in the taxpayer's depreciable real property is then reduced by the same amount as the excluded debt relief. This reduction takes place generally at the beginning of the tax year immediately following the debt relief. However, if the property that will have its basis reduced is sold prior to the beginning of the tax year in which its basis will be reduced, the basis reduction is treated as having taken place immediately prior to the sale. The basis reduction is treated as additional depreciation for recapture purposes; the accumulated straight-line depreciation used to calculate the amount subject to recapture is not adjusted. Therefore, in those cases, the entire amount of the basis reduction would be treated as recapture, rendering the basis reduction ineligible for installment sale treatment when the property is sold.

Bankruptcy and insolvency exceptions

The exclusions under Sec. 108(a)(1)(A) and (B) (the Title 11 and insolvency exceptions) take precedence over Sec. 108(a)(1)(D) (the qualified real property business indebtedness exception). In many cases, the Title 11 or the insolvency exception will provide a better tax result to the taxpayer than will the qualified real property business indebtedness exception. The reduction of tax attributes other than the depreciable basis in real property may provide a vehicle to use carryover tax attributes that might otherwise expire. To the extent that the used carryovers would have expired prior to their usage, a permanent reduction in tax liability would result. The usage of the real property business indebtedness exception would only represent a timing difference in the payment of tax, either through reduced future depreciation deductions or increased gain on sale of the asset at a later date.

Tax advisers should explore the value of electing to carry forward an insolvent taxpayer's net operating loss (NOL) when there is a likelihood of requesting debt relief from a lender. Carrying back the NOL to prior years may result in some of it being absorbed by personal exemptions and low tax rates.

In addition, some taxpayers are now seeing the result of years of bad tax shelter investments in the form of debt relief income and gains from foreclosure sales. New Sec. 108 may offer some relief to investors with partnership interests when there is a passthrough of debt relief income. Sec. 108 generally does not apply to gains resulting from foreclosure sales.

Recourse indebtedness treatment

If recourse indebtedness is foreclosed or otherwise satisfied with a transfer of property at less than the face value of a debt, two things happen. First, a gain or loss on sale is computed by comparing the FMV of the property transferred to its adjusted basis in the hands of the transferor. Second, the remaining recourse indebtedness that is discharged is debt relief income subject to possible exclusion under Sec. 108.

Nonrecourse indebtedness treatment

Many tax shelter partnerships were set up with nonrecourse indebtedness which would not follow the same logic. The entire amount of nonrecourse indebtedness is considered to be the sale price of the foreclosed property, regardless of the FMV of the property transferred. Hence, the gain resulting from the foreclosure of nonrecourse indebtedness is generally not eligible for exclusion under any of the provisions of Sec. 108.

Despite this treatment of nonrecourse indebtedness, the U.S. Bankruptcy Court has determined that a bankruptcy estate was allowed to exclude debt relief income resulting from foreclosure actions in partnerships in which the debtor was a partner (In re John R. Pflug, Jr., Bank. Ct. Va., 1992). In its memorandum decision, the court stated: "This court is not concerned with the tax accounting debate of whether the partnership received 'sale and exchange' or 'discharge of indebtedness' income ....The substantive character of the income that is allegedly attributable to this debtor's estate is clearly forgiveness of indebtedness income that is excluded from gross income under [Sec. 108] and 11 U.S.C. [sections]346(j)(1)." It is not known whether the indebtedness in question was recourse or nonrecourse, but given the court's disposition, the character of the liability may not have mattered.

This decision, while small in scope, does give some measure of hope to those unlucky taxpayers encumbered by disintegrating tax shelters. Presumably this decision can be used as precedent in a bankruptcy court, and may be applicable to any insolvent taxpayer.

Mixed recourse and nonrecourse indebtedness treatment

In some cases, a taxpayer's investment in a limited partnership involves both qualified nonrecourse and recourse indebtedness. In the event of foreclosure on the underlying property in the partnership resulting in debt relief, presumably the foreclosure sale proceeds would be first applied to offset the nonrecourse indebtedness and lastly against the recourse indebtedness. Since the sale proceeds would first be applied to offset the nonrecourse indebtedness, the recourse indebtedness would still remain at least partially unpaid. To the extent the sale proceeds are insufficient to pay the full balance of the nonrecourse indebtedness, some nonrecourse and the recourse indebtedness would remain and, therefore, both sets of rules would apply.

Structuring to avoid "sale or exchange" treatment

An alternative structure to avoid a foreclosure on nonrecourse indebtedness resulting in "sale or exchange" treatment is to follow the logic in McAlpine Land & Development, 43 BTA 520 (1941). In McAlpine, the taxpayer transferred cash to the lender in an amount less than the full face value of the debt in exchange for the debt, which was then canceled. The reduction in indebtedness resulting from this transaction resulted in debt relief income and not foreclosure sale gain.

While the bankruptcy court's decision in Pflug does give some hope to a bankrupt taxpayer with foreclosures on partnership property, it is more prudent to structure an impending foreclosure to include a transfer of property in exchange for the bank's agreement to take less than the full face amount on the note(s). Based on McAlpine, by transferring property in addition to the encumbered property, the gross income from sale or exchange is limited to the FMV of the property transferred, converting any excess nonrecourse indebtedness to debt relief income.

From David P. Dillwood, CPA, Zainer Rinehart Clarke, Santa Rosa, Cal.