Reduction of nonrecourse debt.

Example: D borrowed $1,000,000 from C in 1991. D had no personal liability for this debt, which was secured by an office building (valued at $1,000,000) that D acquired from S with the proceeds of the nonrecourse financing. In 1992, when the building's value was $800,000 and the amount of the debt was still $1,000,000 C reduced the debt to $800,000. When the debt was reduced, D was not bankrupt or insolvent.

What is the amount, if any, of D's debt discharge income?

Under Fulton Gold Corp., 31 BTA 519 (1934), D has no debt discharge income. However, D's basis in his office building must be reduced by $200,000.

On the other hand, under Rev. Rul. 91-31, D has $200,000 debt discharge income. The basis in D's office building is not reduced by this $200,000 debt reduction. (See the Tax Clinic item, "Debt Discharge Guidance Issued," TTA, Jan. 1992, at 25.)

Rev. Rul. 91-31 held that Sec. 61(a)(12) provides that gross income includes income from the discharge of indebtedness. Regs. Sec. 1.61-12(a) provides that the discharge of indebtedness, in whole or in part, may result in the realization of income.

In Rev. Rul. 82-202, a taxpayer prepaid the mortgage held by a third-party lender on the taxpayer's residence for less than the mortgage's principal balance. At the time of the prepayment, the residence's fair market value (FMV) was greater than the mortgage's principal balance. That ruling held that the taxpayer realized discharge of indebtedness income under Sec. 61(a)(12), whether the mortgage was recourse or nonrecourse and whether it was partially or fully prepaid. Rev. Rul. 82-202 relied on Kirby Lumber Co., 284 US 1 (1931), in which the Supreme Court held that a taxpayer realized ordinary income on the purchase of its own bonds in an arm's-length transaction at less than their face amount.

In Tufts, 461 US 300 (1983), the Supreme Court held that when a taxpayer sold property encumbered by a nonrecourse obligation that exceeded the property's FMV, the amount realized included the amount of the obligation discharged. Because a nonrecourse note was treated as a true debt on inception (so that the loan proceeds were not taken into income at that time), a taxpayer was bound to treat the nonrecourse note as a true debt when the taxpayer was discharged from the liability on disposition of the collateral, despite the collateral's lesser FMV (see Regs. Sec. 1.1001-2(c), Example 7).

In Gershkowitz, 88 TC 984 (1987), the Tax Court concluded that the settlement of a $250,000 nonrecourse debt for a $40,000 cash payment (rather than surrender of the $2,500 collateral) resulted in $210,000 of discharge of indebtedness income. Following the Tufts holding, the court held that the discharge from a portion of the liability for an undersecured nonrecourse obligation through a cash settlement must also result in income.

The IRS will follow the holding in Gershkowitz where a taxpayer is discharged from all or a portion of a nonrecourse liability when there is no disposition of the collateral.

In Fulton Gold Corp., the taxpayer purchased property without assuming an outstanding mortgage and subsequently satisfied the mortgage for less than its face amount. The Board of Tax Appeals, for purposes of determining the taxpayer's gain or loss on the sale of the property in a later year, held that the taxpayer's basis in the property should have been reduced by the amount of the mortgage debt forgiven in the earlier year.

The Tufts and Gershkowitz decisions implicitly reject any interpretation of Fulton Gold that a reduction in the amount of a nonrecourse liability by the debt holder who was not the seller of the property securing the liability results in a basis reduction for that property, rather than discharge of indebtedness income for the year of the reduction. Fulton Gold, interpreted in this manner, is inconsistent with Tufts and Gershkowitz. Therefore, that interpretation is rejected and will not be followed.

In, view of the foregoing, the Service's current position should be considered in rendering advice or in preparing income tax returns, unless the contrary position in Fulton Gold is advised and/or taken. To avoid the possibility of the 20% accuracy-related and preparer penalties, this contrary position should be disclosed on Form 8275. If a nonsigning preparer does not control the return, disclosure should be made by advising the taxpayer and/or another preparer that disclosure on Form 8275 may be necessary to avoid possible penalties (see Regs. Sec. 1.6694-2(c)(3)(ii). In either situation, the possible additional tax and interest should be discussed with the client.

Of course, disclosure is not available if the position on the return is attributable to a "tax shelter" (as defined in Sec. 6662(d)(2)(C)(ii) and Regs. Sec. 1.6662-4(g)(2)).

Disclosure also cannot be used for a "frivolous" position. A frivolous position is one that is "patently improper" (see Regs. Secs. 1.6662-3(b)(3) and 1.6694-2(c)(2)). However, a position contrary to Rev. Rul. 91-31 might not be frivolous in view of the following excerpt from footnote 11 in the Supreme Court's Tufts decision.

The Commissioner also has chosen not to characterize the transaction as cancellation of indebtedness. We are not presented with and do not decide the contours of the cancellation-of-indebtedness doctrine. We note only that our approach does not fall within certain prior interpretations of that doctrine. In one view, the doctrine rests on the same initial premise as our analysis here--an obligation to repay--but the doctrine relies on a freeing-of-assets theory to attribute ordinary income to the debtor upon cancellation.... According to that view, when nonrecourse debt is forgiven, the debtor's basis in the securing property is reduced by the amount of debt canceled, and realization of income is deferred until the sale of the property. See Fulton Gold Corp.... Because that interpretation attributes income only when assets are freed, however, an insolvent debtor realizes income just to the extent his assets exceed his liabilities after the cancellation.... Similarly, if the nonrecourse indebtedness exceeds the value of the securing property, the taxpayer never realizes the full amount of the obligation canceled because the tax law has not recognized negative basis.

Although the economic benefit prong of Crane also relies on a freeing-of-assets theory, that theory is irrelevant to our broader approach. In the context of a sale or disposition of property under [section] 1001, the extinguishment of the obligation to repay is not ordinary income; instead, the amount of the canceled debt is included in the amount realized and enters into the computation of gain or loss on the disposition of property. According to Crane, this treatment is no different when the obligation is nonrecourse: the basis is not reduced as in the cancellation-of-indebtedness context, and the full value of the outstanding liability is included in the amount realized. Thus, the problem of negative basis is avoided. (Emphasis added).

If the seller of specific property reduces the purchaser's debt that arose out of the purchase, and the reduction to the purchaser does not occur in a bankruptcy case or when the purchaser is insolvent, the reduction to the purchaser of the purchase-money debt is to be treated (for both the seller and the buyer) as a purchase price adjustment on that property. This rule applies only if, but for this rule, the amount of the reduction would be treated as debt discharge income.

If the debt has been transferred by the seller to a third party (whether or not related to the seller), or if the property has been transferred by the buyer to a third party (whether or not related to the buyer), this rule does not apply to determine whether a reduction in the amount of purchase-money debt should be treated as debt discharge income or a true price adjustment. Also, this rule does not apply if the debt is reduced because of factors not involving direct agreements between the buyer and the seller, such as the running of the statute of limitations on enforcement of the obligation. (See the Senate Finance Committee Report on Sec. 108(e)(5), added by the Bankruptcy Tax Act of 1980.)

See also the Tax Clinic item, "Insolvency Tax Planning Ideas," TTA, Mar. 1992, at 158.

From Michael f. Perkins, CPA, Atlanta, Ga., Jeffrey A. Kelson, CPA, Miami, Fla., and Richard N. Kipper, CPA, Los Angeles, Cal.