Should installment obligations be canceled as gifts?

As the recent economic downturn has caused a decline in the value of real estate and as longtime, healthy businesses begin to falter, there may be some good news for the next generation. This may be a great time for older generation owners to transfer property to the younger generation. If outright gifts are not palatable, older generation owners may want to consider using an installment sale, possibly coupled with the option of later canoeling the obligation payments as gifts.

One potential technique is an installment sale to the younger generation. If the sales price is adequate, the sale should not be treated as a gift. If the interest rate charged is lower than the growth rate of the property transferred, there is a gift or estate tax savings. To reduce the seller's estate further, some practitioners have suggested canceling the installment obligation payments as they become due, with each cancellation qualifying for the annual gift tax exclusion. But is canceling the payments the best tax strategy, or should the payments be made with cash given at an earlier date in the year?

The giving of cash and the retum of that cash by the donee as payment on the installment note results in: --reduced estate of the donor [through annual exclusion gift] --interest income to the donor; --interest expense to the donee; --principal payment to the donor; the exclusion is permanent or merely a deferral. Since insolvency is the key to exclusion, it is important to know how to define this term.

The determination of insolvency is made immediately prior to discharge and is defined under Sec. 108{d}(3) as the excess of the taxpayer's liabilities over the fair market value [FMV] of its assets. Since the Code does not provide a definition of "liabilities," this term has become a matter of judicial and legislative interpretation. The rationale has always been to provide the taxpayer with a "fresh start" not hampered by the imposition of a tax that the taxpayer is unable to pay.

Until now, there has been some uncertainty as to how nonrecourse debt is treated for purposes of determining insolvency under Sec. 108[d](3). The IRS recently clarified its position on the treatment of nonrecourse liabilities, as it relates to the determination of insolvency within the meaning of Sec. 108[d][13], in Rev. Rul. 92-53.

Under the "fresh start" approach, in determining insolvency under Sec. 108[d][3], the discharged nonrecourse debt in excess of the property's FMV should be considered a liability. Any nonrecourse debt in excess of the FMV of its underlying property not discharged is not considered a liability in the insolvency determination.

The example above illustrates the computation of insolvency under Sec. 108(d)(3) when nonrecourse debt is involved., either as the discharged debt (Situation 1) or nondischarged debt (Situation 2). Under Situation 1, the taxpayer would have income from discharge of indebtedness in the amount of $50,000, the .amount by which the discharged debt exceeds the insolvency. In Situation 2, the entire amount would be income.

As this example illustrates, the computation of insolvency and the availability of exclusion under Sec. 108 will differ depending on the type of debt discharged.

In this current economic climate, especially as it relates to real estate, Rev. Rul. 92-53, as well as the exclusion provisions of Sec. 108, can have a significant impact on current income recognition and planning for transactions involving discharge of indebtedness.

From Arnold Haskell, CPA, Melville, N.Y.