Insolvency tax planning ideas.

An unfortunate byproduct of the early 1990s is an increased emphasis on discharge of indebtedness (DOI) income issues.

Sec. 108(a) excludes from gross income any amount that would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if

--the discharge occurs under Title 11 of the U.S. Code (the 1978 Bankruptcy Code),

--the discharge occurs when the taxpayer is insolvent, or

--the indebtedness discharged is qualified farm indebtedness.

In the case of insolvency, the gain is excluded to the extent of the taxpayer's insolvency.

In addition, Sec. 108(b) requires that certain tax attributes be reduced as a result of this exclusion of gain from DOI.

Clearly, these provisions are meant to ameliorate what could otherwise be very difficult tax consequences at a time when the taxpayer is in precarious fiscal straits. However, the attribute reduction trade-off reminds us that this process is not an easy one. Nevertheless, the following example and the ensuing discussion of planning devices show that proper planning can still swing the pendulum a little further in the taxpayer's direction.

Example: Partner X is insolvent, but has not filed for bankruptcy because of the cost of bankruptcy administration and the stigma attached. In addition, X has passive loss carryovers in the amount of $2,000,000. X has a 50% share of a real estate partnership, Y, which is on the verge of returning rental properties to lenders, renegotiating its debts or selling its properties at a loss. Y also has vacant land that would result in portfolio gain or loss if sold or returned to the lender. Y has some flexibility as to the timing of the return of its properties.

Along with other real estate, Y owns other properties with potential gains if sold. Regs. Sec. 1.1001-2(c), Example 8, states that a transfer of property in exchange for outstanding recourse indebtedness will result in an amount realized from a disposition of property for the excess of the fair market value (FMV) of the property over its basis and DOI income for the remainder of the debt. If the debt is nonrecourse, the entire amount of the debt is treated as an amount realized under Regs. Sec. 1.1001-2(c), Example 7, which is income whether or not the debtor is insolvent or in bankruptcy.

The worksheet above illustrates the results of the transfer of various properties of the Y partnership.

X would also have $4,500,000 of DOI income, but if his insolvency is greater than this amount, X will exclude the DOI income. However, the NOL of $2,003,000 and the capital loss carryover of $397,000 must be reduced to zero under the Sec. 108(b) attribute reduction.

X could achieve more favorable results with certain other courses of action.

* Control the timing of the transactions: Y should return only rental building A to the lender in 1991. X's $2 million of recognized Sec. 1231 gain would be offset by the $2 million passive loss carryovers. The vacant land would be returned to the lender in a later year so that the $2.4 million of capital loss would be available in the future against other potential capital gains. As a result, neither the NOL nor the capital loss carryover would be reduced due to Sec. 108.

* Use redemption rights: A second planning device is to control the timing of the recognition of the gain if foreclosure by the lender occurs. If, after a foreclosure sale by the lender, Y retains the right to redeem the property, the taxable gain or loss might not occur until this right of redemption expires. If the right of redemption expires in a year following the year of foreclosure, the gain or loss can be accelerated into the current year, if needed, by abandoming the property. This abandonment coul be done by a quitclaim deed.

* Reduce nonrecourse debt prior to foreclosure: If rental building B is subject to nonrecourse financing, it may be possible that an insolvent taxpayer could arrange with the lender to have a portion of the debt forgien as early as possible, in the event that deeding the property to the lender becomes a future reality. This may result in part of all of the forgiveness of debt income under Sec. 108.

* Minimize attribute reduction: A fourth planning device available to reduce an NOL or other loss/credit not fully used by year-end is to transfer property into a corporation in a Sec. 351 transfer. Sec. 357(c) considers the excess debt over basin in a Sec. 351 transfer as a gain from the sale or exchange of a capital asset. By transferring the property to a corporation, gain is recognized and the NOL is reduced and not lost due to the Sec. 108 attribute reduction.

From Catherine M. Skiles, CPA, Colorado Springs, Colo.