Proposed regs. on basis reduction after excluded discharge of indebtedness income.

In early 1997, the IRS issued proposed regulations on the reduction of basis of property due to discharge of indebtedness (DOI) income. The proposed regulations cover basis reductions when DOI income is excluded because of the debtor's bankruptcy or insolvency or when the debt is qualified farm indebtedness. The proposed regulations also cover the election to seduce the basis of depreciable property (1) in lieu of other tax attributes and (2) when qualified real property business indebtedness (QRPBI) is discharged.

In general, Sec. 108(a) excludes from gross income any DOI income if the discharge occurs in either a Tide 11 case (bankruptcy), when the taxpayer is insolvent or if the debt is "qualified farm indebtedness" or (if so elected) "qualified real property business indebtedness." Under Sec. 108(b), taxpayers generally must reduce specified tax attributes, including adjusted bases of properties, to the extent DOI income is excluded from gross income. Sec. 108(b)(2) requires a taxpayer to reduce tax attributes in the following order: (A) net operating losses; (B) general business credits; (C) minimum tax credits; (D) capital loss carryovers; (E) adjusted bases of property; (F) passive activity loss and credit carryovers; and (G) foreign tax credit carryovers.

In lieu of the order of attribute reduction specified by Sec. 108(b)(2), a taxpayer may elect under Sec. 108(b)(5) to first reduce the adjusted basis of depreciable property (real and personal) to the extent of the excluded DOI income. If the debt is QRPBI and the debtor is neither in bankruptcy nor insolvent, an election may be made to exclude DOI income and reduce depreciable basis in real property (Sec. 108(a)(1)(D) and (c)).

Sec. 1017 provides rules for the basis reductions required by or elected under Sec. 108. When basis reductions are necessary, Sec. 1017(a) requires the taxpayer to reduce the adjusted bases of property held on the first day of the following tax year. Sec. 1017(b)(1) provides that the amount of the basis reduction required under Sec. 1017(a) and the particular properties, the bases of which are to be reduced, shall be determined under regulations. Sec. 1017(b)(2) limits the basis reduction for debt discharged in bankruptcy or when the taxpayer is insolvent to the excess of the aggregate adjusted bases of the taxpayer's assets immediately after the discharge over the amount of remaining liabilities.

The proposed regulations modify the limitation on basis reductions under Sec. 1017(b)(2). Prop. Regs. Sec. 1.1017-1(b)(3) requires the amount of any basis reduction for DOI income of a bankrupt or insolvent debtor under Secs. 108(b)(2)(E) and 1017(b)(2) not to exceed the excess of (1) the aggregate of the adjusted bases of property and the amount of money held by the taxpayer immediately after the discharge over (2) the aggregate of the liabilities of the taxpayer immediately after the discharge. The inclusion of money in the adjusted bases of assets for this calculation is different from current Regs. Sec. 1.1017-1(b)(1), which specifically defines property not to be money in most cases. .

The proposed regulations generally retain a"tracing" approach to basis reduction similar to the current Sec. 1017 regulations. The proposed regulations require a taxpayer to reduce the adjusted basis of any property that secured the discharged debt before reducing the adjusted basis of other property.

Prop. Regs. Sec. 1.1017-1(a) modifies the categories in the existing regulations to simplify the process of basis reduction. First, the distinction between purchase money debt and other secured debt is eliminated. Second, the new order of basis reduction for property is as follows:

1. real property used in the taxpayer's trade or business or held for the production of income (other than Sec. 1221 (1) real property) that secured the discharged debt.

2. personal property used in the taxpayer's trade or business or held for the production of income (other than inventory, accounts receivable and notes receivable) that secured the discharged debt.

3. remaining property used in a trade or business or held for investment (other than inventory, accounts receivable and notes receivable and real property described in Sec. 1221(1)).

4. inventory, accounts receivable, notes receivable and real property described in Sec. 1221(1).

5. property not used in a trade or business nor held for investment.

Any change in security for a debt within one year before the discharge of such debt will be disregarded if the principal purpose of such change was to affect the application of Sec. 1017 (Prop. Regs. Sec. 1.1017-1(d)). If the taxpayer has DOI income attributable to more than one discharged debt, the tax attribute reduction is allocated among the debt in proportion to the amount of DOI income attributable to each discharged debt (Prop. Regs. Sec. 1.1017-1(b)(2)). Any reduction to depreciable real property for purposes of the QRPBI exception must be applied first to the adjusted basis of the qualifying real property (Prop. Regs. Sec. 1.1017-1(c)(1)).

The proposed regulations modify a partner's ability to elect to treat his partnership interest as depreciable property. Sec. 1017(b)(3)(C) provides that a taxpayer may elect to treat a partnership interest as depreciable property when reducing adjusted bases under Sec. 108(b)(5) and as depreciable real property when reducing adjusted bases under Sec. 108(c), to the extent the partnership correspondingly reduces the partner's proportional interest in the adjusted bases of depreciable property (or depreciable real property) held by the partnership (inside basis).

Prop. Regs. Sec. 1.1017-1(f) provides that a partner may elect to request that a partnership reduce its inside basis and thereby permit the partner to treat the partnership interest as depreciable property (or depreciable real property). However, a partner is required to request such consent from the partnership if the partner owns (directly or indirectly) a greater than 50% capital and profits interest in the partnership, or if the partner receives a distributive share of DOI income from it. In addition, f such requests for consent are made by partners owning a total (directly or indirectly) of more than 50% of the capital and profits interest in the partnership, the partnership is required to grant such consent to reduce inside basis.

A consenting partnership must include with Form 1065, U.S. Partnership Return of Income, for the tax year of the partnership that ends with or within the tax year the partner excludes DOI income from gross income under Sec. 108(a), a statement that includes the name, address and taxpayer identification number of the partnership and states the amount of the reduction of the partner's proportionate interest in the adjusted bases of the partnership's depreciable property or depreciable real property (which-ever is applicable).

A copy of this statement must also be provided to the taxpayer partner. The statement must then be attached to a taxpayer's timely filed (including extensions) federal income tax return for the tax year in which the taxpayer has DOI income excluded from gross income under Sec. 108(a).

Effective Date

The regulations will be effective for DOI occurring on or after the date these regulations are published as final regulations in the Federal Register; as they are written, there are no provisions for elective retroactivity. If a taxpayer has attribute reduction from DOI in-come, Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, must be attached to a timely filed return (including extensions) for the year of discharge. In addition, any elections on the reduction first of depreciable property in lieu of other attributes or QRPBI must be made on a timely filed (including extensions) Form 982. These elections may be revoked only with consent of the Service.