New exclusion for income from discharge of real property business debt: partners v. partnership.

Under new Sec. 108(a)(1)(D) and (c), for a non-C corporation payer, income from post- 1992 discharge of qualified real property business indebtedness" (QRPBI) is excluded from gross income subject to limitations. Under Sec. 108(c)(3), QRPBI must be - incurred or assumed by the taxpayer in connection with real property used in a trade or business and be secured by that property, and - incurred or assumed before 1993 or, if incurred or assumed after 1992, "qualified acquisition indebtedness."

Qualified acquisition indebtedness must be incurred or assumed to acquire, construct, reconstruct or substantially improve real property used in a trade or business and must be secured by that property (Sec. 108(c)(4)).

Sec. 108(c)(3)(C) also requires the taxpayer to elect the application of Sec. 108(c)(3) to debt that would otherwise qualify as QRPBI. Under Ann. 94-11, this election must be made by checking a new box on the December 1993 revision of Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). The January 1995 revision of this form must be used for debt discharges in tax years beginning after 1993.

If QRPBI is refinanced, the new debt will be QRPBI only to the extent it does not exceed the QRPBI being refinanced. (See House Report, at 185, on the Revenue Reconciliation Act of 1993.)

The existing gross income exclusions for debt discharges occurring in a Title 1 1 case or when a taxpayer is insolvent take priority over this new QRPBI exclusion (Sec. 108(a)(2)). However, under Sec. 108(d)(6), the exclusion of income from the discharge of QRPBI is applied at the partner level (on a partner-by-partner basis) and not at the partnership level. Therefore, a partner's solvency status (instead of the partnership's) is relevant. Accordingly, a partnership's insolvency will not preclude a solvent partner from using these new QRPBI rules.

The Sec. 108(c)(3)(C) election must be made on the taxpayer's return for the tax year in which the discharge occurs (or at such other time as permitted by regulations) (Sec. 108(d)(9)).

Under Sec. 108(c)(2), the amount of QRPBI discharge income that may be excluded from gross income under Sec. 108(a)(1)(D) cannot exceed the excess of - the debt's outstanding principal amount, over - the fair market value (FMV) of the real property securing that debt, reduced by the outstanding principal amount of any other QRPBI secured by such property. This excess is measured immediately before the QRPBI is discharged.

Additionally, under Sec. 108(c)(2)(B), the amount of QRPBI discharge income excluded from gross income cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge. Aggregate adjusted basis is determined as of the first day of the next tax year (or, if earlier, the date of disposition) and after any reductions under Sec. 108(b) or (g) (dealing with tax attributes and qualified farm indebtedness, respectively). However, depreciable real property acquired in contemplation of the discharge is eliminated in computing this overall limitation.

Even though the election to treat otherwise qualifying debt as QRPBI is made at the partner level, the House Report indicates that, in the case of the discharge of a partnership's debt, the determination of whether that debt is QRPBI and the application of the FMV limitation is made at the partnership level.

QRPBI discharge income excluded under Sec. 108(a)(1)(D) must be applied to reduce the basis of the taxpayer's depreciable real property (Sec. 108(c)(1)). This basis reduction generally is made at the beginning of the tax year following the tax year in which the discharge occurs. However, if such property is disposed of before that time, its basis is reduced immediately before the disposition.

Under Sec. 1017(b)(3)(C) and (F), for purposes of this basis reduction, a partner's interest in a partnership is treated as depreciable real property to the extent of that partner's proportionate interest in the partnership's depreciable real property, but only if there is a corresponding reduction in the partnership's basis in depreciable real property with respect to such partner.

However, the overall basis limitation (under Sec. 108(c)(2)(B)) is applied at the partner level pursuant to Sec. 108(d)(6). In the case of a discharge of a partnership's debt, the House Report states:

An interest of a partner in a partnership that owns depreciable real property is treated as depreciable real property to the extent of the partner's proportionate interest in the depreciable real property held by the partnership. The partnership's basis depreciable real property with respect such partner is correspondingly (Emphasis added.)

On the other hand, this report further explains the treatment the deemed distribution arising from the reduction in a partner's share of partnership liabilities attributable to the discharge of partnership debt:

The allocation of an amount of debt discharge income to a partner results in that partner's basis in the partnership being increased by such amount (sec. 705). The reduction in a partner's share of partnership liabilities caused by the debt discharge also results in a deemed distribution (under sec. 752) which in turn results in a reduction (under sec. 733) of the partner's basis in his partnership interest. This section 733 basis reduction is separate from any reduction in basis of the partner's interest under the provision, i.e., the basis reduction that occurs as a result of treating the partnership interest as depreciable real property to the extent of the partner's proportionate interest in the depreciable real property held by the partnership (provided the partnership makes a corresponding reduction in the basis of depreciable partnership real property with respect to that partner). (Emphasis added.)