Deferring DOI income and resulting tax.

This is the third in a series of four articles summarizing some of the federal, New York State and New York City tax consequences of real estate foreclosures, bankruptcies and workouts. The articles will serve as text for a seminar on the tax consequences of these transactions to be co-sponsored by the law firm of Ziegler, Sagal, & Winters and Real Estate Weekly on June 25 at the Grand Hyatt Hotel from 8:30 a.m. to 11:00 a.m.

Cancellation of Indebtedness Income

The previous article explained that when the fair market value (FMV) of property declines below the amount owed on the mortgage and the owner is forced to surrender the property to the creditor, or reaches an agreement with the creditor to modify the mortgage, the owner may realize taxable income (discharge of indebtedness income or "DOI Income"). DOI Income may be realized even though the owner appears to have suffered an economic loss. This article discusses various strategies for deferring tax which would otherwise result from the DOI Income.

DOI Income -- In General

The rationale for imposing a tax on DOI income may be illustrated by the following example:

If you borrowed $100, you would have cash assets with an FMV of $100, liabilities of $100 and a net worth of zero. However, if the lender discharged the debt, you would have $100 of assets, no liabilities and a net worth of $100. Thus, for income tax purposes, you would be considered to have been enriched by $100 and, therefore, will realize DOI Income of $100.

Deferral of DOI Income

DOI Income can be deferred under the following circumstances: * When a debtor is partially discharged from a purchase money mortgage (i.e., the creditor received the mortgage as consideration for selling the property). In this situation, rather than recognizing DOI Income, the debtor's tax basis in the property will be reduced by the amount of the debt discharged.

For example, you buy a property for $25 cash and a $100 purchase money mortgage, paying interest only for five years. Three years later, you and the seller agree to reduce the principal amount of the mortgage from $100 to $75. As a result of the $25 reduction in the mortgage, you may reduce your basis in the property by $25 without recognizing DOI Income.

The effect of reducing the tax basis of the property is that the owner will defer the DOI Income until he sells the property. This rule applies only to adjustments between the original buyer and seller. * DOI Income will also be deferred to the extent that a debtor is insolvent. A debtor is insolvent to the extent his liabilities exceed the FMV of his assets.

For example, if your sole asset had a FMV of $100, but was subject to $200 in liabilities you would be insolvent by $100. If a creditor discharged $125 of these liabilities, you would then have assets of $100 and liabilities of $75 and, therefore, a net worth of $25. In this case, you will have DOI Income of $25 (the amount by which you were made solvent by the discharge of debt).

The law is not clear on whether and to what extent contingent liabilities are included in determining a debtor's solvency. * A debtor will not be required to realize DOI Income if the discharge of debt occurred in a bankruptcy reorganization.

Generally, for every dollar of DOI Income which is avoided because of insolvency or bankruptcy, certain tax attributes (i.e., the debtor's loss carryovers and/or tax basis of his assets) must be reduced by $1. The effect of these adjustments is to defer the recognition of this income to future years.

To illustrate, again assume that your sole asset has a $100 FMV which is subject to $200 of liabilities and the lender agrees to discharge $125 of these liabilities. As explained above, since the discharge only made you solvent by $25, $100 of the DOI income is avoided. However, you would be required to reduce the tax basis in your property by $100. Thus, if the original basis of your property was $100, you would reduce your basis to zero. Accordingly, when you sell the property, you will recognize $100 of income (assuming that the fair market value of the property remains the same). Thus, the DOI Income which was excluded at the time of discharge will be deferred until the property is sold.

Property planning can allow a debtor to defer the recognition of this DOI Income indefinitely. Various elections are available which allow the taxpayer to plan the order in which the loss carryovers and basis are reduced and, in the case of reduction in basis, the properties affected. Generally, maximum deferral of DOI Income is achieved by reducing the basis of property to be held for a long period of time.

The adjustments to basis are made to property held by the debtor at the beginning of the year after the discharge of indebtedness occurs. In some circumstances it is desirable for the debtor to acquire property with sufficient tax basis on n "soak-up" the adjustments and preserve loss carryovers. Since debtors in this situation typically have limited cash, they face the challenging task of acquiring properties with a reliable cash flow for little cash down.

In summary, the debtor can maximize the deferral of the DOI Income by timing the transactions which result in DOI Income, making the most advantageous elections for reducing tax attributes and, in some cases, by acquiring additional properties. Stephen S. Zielger is a member of Ziegler, Sagal & Winters, P.C., a New York City law firm exclusively for the practice of business and personal tax planning, tax controversy work and estate planning. Lanny M. Sagal and Alan Winters also contributed to this article.