Consider disposing of depreciable real property or making a sec. 108(c)(3)(C) election in the same year that debt is discharged.
However, when encumbered property is transferred in a foreclosure or in lieu of foreclosure, the recognition of discharge of indebtedness income depends on whether the debt is recourse or nonrecourse. Under Regs. Sec. 1.1001-2(a), relief from indebtedness resulting from the transfer of property encumbered by nonrecourse debt is deemed derived from the disposition of such property. Therefore, the gain is treated as part of the amount realized from the sale or exchange of the property and no discharge of indebtedness income results. Alternatively, under Regs. Sec. 1.1001-2(c), Example 8, and Danenberg, 73 TC 370 (1979), relief from indebtedness resulting from the transfer of property encumbered by recourse debt may be both discharge of indebtedness income and gain derived from the disposition of the property. The regulations appear to bifurcate the transaction, and provide that gain from the sale or exchange of property arises to the extent that the property's fair market value (FMV) exceeds its basis and debt discharge income arises to the extent of the excess of the debt over the FMV.
Under Sec. 108(a), amounts includible in gross income resulting from discharge of indebtedness income may be excluded when the discharge occurs in a bankruptcy proceeding, while the debtor is insolvent, if the debt is qualified farm indebtedness, or if the debt is qualified real property business indebtedness and an election under Sec. 108(c) (3) (C) is made by a non-C corporation tax-payer. Hence, if debt is relived through the transfer of nonrecourse encumbered property, it appears that the Sec. 108(a) exclusions are inapplicable.
As a general rule, if debt forgiveness income is excluded, a reduction of specified tax attributes is required under Sec. 108(b) for Sec. 108(a) (1) (A), (B) or (C) exclusions, and pursuant to Sec. 108(c) (1) for Sec. 108(a) (1) (D) exclusions. Under Sec. 1017(a), the amount excluded from gross income under Sec. 108(a), which is applied to reduce basis pursuant to Sec. 108(b) (2) (D) [sic] (E), (b) (5), or (c) (1), is applied to reduce the basis of property held by the taxpayer at the beginning of the tax year following the tax year in which the discharge occurs. Accordingly, if the discharge is excluded from income under Sec. 108(a) (1) (A) or (B), when the taxpayer is bankrupt or insolvent, and no other Sec. 108(b) (2) attributes exist, to the extent the taxpayer converts the property into money or disposes of the property before the next tax year, no attribute reduction results and a permanent exclusion from gross income is obtained.
However, if relief is only available and elected under Sec. 108(c) (3) (C), and the taxpayer disposes of depreciable real property (see Sec. 108(c) (2) (B) either in a transaction giving rise to the discharge or otherwise, before the first day of the next tax year, Sec. 1017(b) (3) (F) requires a reduction in the basis of such property immediately before its disposition. Therefore, if the taxpayer is neither bankrupt nor insolvent, electing the Sec. 108(a) (1) (D) exclusion reduces the property's basis. As a result, what would otherwise be ordinary income produces capital gain.
(See also Tax Clinic, "New Exclusion for Income From Discharge of Real Property Business Debt: Partners vs. Partnership," TTA, May 1994, p. 289.)