The sec. 108(c)(3)(C) election: clarification and amplification.

Under Sec. 108(a) amounts resulting from discharge of indebtedness income may be excluded from gross income resulting from discharge of be excluded from gross income if the debit is qualified real property business indebtedness (QRPBI) and an election under Sec. 108(c)(1)and 1017(a) C corporation taxpayer. However under Secs. 108(c)(1) and 1017(a) when the election is made, the amount of discharged QRPBI excluded from gross income must reduce the basis of depreciable red property held by the taxpayer at the beginning of of the tax year following the tax year m which the debt discharge occurred; see Tax Clinic, "Consider Disposing of Depreciable Real Property or Making a Sec. 108(c)(3)(C) Election in the Same year that Debt is Discharged" TTA May 1996, p 269.

The penultimate paragraph of that prior Tax Clinic item stated:

However, if relief is only available and elected under Sec. 108(c)(3)(C), and them taxpayer disposes of depreciable real property (see Sec. 108(c)(2)(B) either in a giving rise to die discharge or otherwise, before the first day of die next tax year, Sec. 1017(b)(3)(F) requires a reduction in die basis of such property immediately before its disposition. Therefore, if die taxpayer is neither bankrupt nor insolvent, electing the Sec. 108(a)(1)(D) exclusion reduces the property's basis. As a result, what would otherwise be ordinary income produces capital gain.

However, Sec. 1017(d)(1)(B) provides that such basis reductions are treated as depreciation deductions subject to Sec. 1250 recapture. On the other hand, in determining the Sec. 1250(b) limitation (additional depreciation) for such recapture, the straight-line depreciation that would have been allowed is computed as if there had been no basis reduction under Sec. 1017 (see Sec 1017(d)(2). In other words the computation of straight-line depreciation under Sec 1250)b) for property whose basis has been reduced under Sec. 1017 is made as if there has been no basis reduction under Sec, 1017 due to discharge of indebtedness. The House Report to the Revenue Reconciliation Act of 1993 states:

If depreciable real property, the basis of which was reduced under this provision is disposed of, then for purposes of determining the amount of recapture under section 1250: (1) any such basis reduction is treated as a deduction allowed for depreciation, and (2) the determination of what would have been depreciation adjustment under the straight line method is made as if there had been no such reduction. Thus, the amount of the basis reduction that is recapture as ordinary income is reduced over the time the taxpayer continues the property, as the taxpayer forgoes depreciation deductions due to the basis deduction. (Emphasis added.) (H. Rep. nO. 103-111, p. 625).

For purposes of the Sec. 1017(a) and 108(c)(1) basis reduction rules, depreciable property as defined by Sec. 1017(b)(3)(B) means any property of a character subject to the allowance of depreciation. Therefore, under Sec. 108(c)(1), it may not be necessary to reduce the basis of the property securing the debt since any depreciable property may be used.

Sec. 1017(b)(3)(F)(iii) reads.

... in the case of property taken into account under section 108(c)(2)(B), the reduction with respect to such property be made as of time before disposition if earlier than time under subsection (a).

Sec. 108(c)(2)(B), in turn, reads:

The amount excluded under subparagraph (D) of subsection (a)(1) shall not exceed the aggregate adjusted bases of depreciable real property (determined after any reductions under subsections (b) and (g) held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of such discharge). (Emphasis added).

Thus, the basis of the property securing the debt might not have to be reduced, since this reduction could apply to any depreciable real property held by the taxpayer. As stated above, Sec. 1017(b)(3)(B) defines depreciable property for Sec. 1017 purposes as "any property of a character subject to the allowance for depreciation...." (Emphasis added.

The House Report included the following example:

[A]ssume that on July 1, 1993, Individual J owns a building worth $150,000, used in his trade or business.. that is subject to a first mortgage securing a debt of J's of $110,000 and second mortgage securing a second debt of J's of $90,000. J is neither a bankrupt nor insolvent and neither debt is qualified farm indebtedness. J agrees with his second mortgagee to reduce die second mortgage debt to $30,000, resulting in discharge of indebtedness income in the amount of $60,000. Under the provision, assuming that J has elect to exclude $50,000 of that discharge from gross income. (Emphasis added.)

Consequently, a QRPBI debtor may convert the recapture of the Sec. 1017(a) basis reduction from ordinary income to capital gain by holding the reduced-basis Sec. 1250 property beyond the year of discharge. This capital gain conversion occurs ratably. Therefore, for each year the debtor holds the reduced-basis property, a greater portion of the potential ordinary income recapture becomes long-term capital gain, with complete conversion at the end of the property's depreciable life.

Example: On Jan. 1, 1994, T purchases a nonresidential building for $900,000 subject to an $800,000 mortgage for nonfarm business use. At Dec, 31, 1995 T's records for this building reveal the following.

Gross basis $900,000

Less:

Accumulated straight-line depreciation

(ignoring the mid-month convention

rounded to the nearest $1,000) 46,000

Adjusted basis 854,000

Fair market value 300,000

Mortgage $800,000

On Dec. 31, 1995, when T is neither bankrupt nor insolvent, the mortgagee cancels this mortgage. Thus, T has $800,000 of debt discharge income. However, under Sec. 108(c)(2)(A) only $500,000 may be excluded from gross income. Therefore, if T elects the Sec. 108(c)@ exclusion, T cm exclude this amount from income add reduce the building's basis by $500,000. Further, the longer T holds this building after the debt discharge, the greater die reduction in potential ordinary income recapture, as shown in the following chart:

(1) (2) (3) (4)

Accumulated Potential

depreciation on Accumulated ordinary income

$400,000 +$500,000 depreciation recapture Year basis reduction on $900,000 (col. 2 - col. 3)

1996 $556,000 $69,000 $487,000 1997 566,000 92,000 474,000 2033 900,000 900,000 0

Therefore, if a mortgage on depreciable real property is discharged and such property is disposed of in the same tax year, a Sec. 108(c)(3)(C)election can currently avoid ordinary income from that debt discharge and allow any capital gun realized to be recognized as capital gain if there is sufficient other depreciable real property to absorb the basis reduction. The longer this other property is held, less the potential for Sec. 1250 ordinary income recapture and correspondingly, the greater the potential for capital gain.

Caution: Sec. 1017(b)(1) pertinently reads as follows:

The amount of reduction to be applied under subsection (a)... and the particular properties the bases of which are to be reduced, shall be determined under regulations prescribed by the Secretary. (Emphasis added.)

To date, no regulations have been proposed on basis reduction attributable to a Sec. 108(c)(3)(C) election.