Troubled debt transactions.

Inconsistencies in IRS Pronouncements Make It Difficult to Avoid Adverse Tax Consequences, Especially in Restructurings Involving Partnership-Debtors

Over the past few years, the Services has issued a number of pronouncements describing the tax treatment of various transactions involving troubled debt. Unfortunately, the rationale behind these pronouncements has been unclear, inconsistent and often contradictory. Thus, in many cases, it remains unclear what the correct tax treatment should be in certain troubled debt transactions, especially in those involving partnership-debtors. This article will discuss the options commonly considerably by lenders and borrowers in troubled debt transactions; examine the inconsistencies in the IRS's pronouncements; and focus on the difficulties faced by taxpayers when the nominal borrower is a partnership. In the process, a consistent logical framework is applied to suggest the correct tax treatment in a variety of troubled debt transactions involving all types of borrowers.

Options Available to the Lender and Borrower

A variety of options are available to lenders holding nonperforming loans. The most direct actions, of course, is foreclosure of the encumbered property (or other collateral) in satisfaction of the outstanding debt balance. Although the most direct action, this alternative is often not desirable due to the depreciated value of the target property, or the inability of the lender to efficiently manage or dispose of the property. One alternative to foreclosure is to renegotiate the terms of the nonperforming loan. Reducing the interest rate may encourage the borrower to continue (or resume) making payments on the loan. A second alternative may be to allow the borrower to settle the obligation at a discount, in effect renegotiating the principal balance rather than the interest rate. In other cases, when both the value of the encumbered property and the value of the borrower's other remaining assets have declined, the lender may accept an equity interest in the borrower (or the borrower's business) in satisfaction of the debt in the hope that future appreciation will be sufficient to offset the loan loss. As each of these alternatives involves distinctly different economic transaction, the tax consequences associated with each also vary.

* Foreclosure transactions - recourse debts

The tax consequences of foreclosure transactions involving recourse debts are well-settled. The regulations under Sec. 1001(1) provide that a foreclosure is treated as a sale of the encumbered property to the lender, but only to the extent of the lesser of the loan's outstanding balance or the property's fair market value (FMV). To the extent that the loan balance exceeds the FMV of the property, and the lender does not further pursue the borrower for satisfaction, the excess is taxable to the borrower as income from the discharge of indebtedness. The lender should be entitled to a bad debt deduction in the same amount.

Example 1: In 1989, B borrowed $100,000 from L to purchase raw land. The land, purchased at a total cost of $125,000, was pledged as security for the note. B also retained personal liability on the debt. In 1993, when the value of the land had fallen to $75,000, L foreclosed on the property in full satisfaction of the remaining $90,000 principal balance of the loan. B will be treated as selling the property to L for its FMV of $75,000, triggering a $50,000 loss ($75,000 sales proceeds - $125,000 original cost). This loss may or may not be deductible, depending on the nature of B's investment in the land. In addition, B will recognize $15,000 in income from the discharge of indebtedness ($90,000 outstanding loan balance - $ 75,000 FMV transferred in satisfaction of the loan). If B is solvent, this income is fully taxable on B's 1993 tax return. L will be entitled to a $15,000 debt deduction.

* Foreclosure transactions - nonrecourse debts

When foreclosure occurs on a nonrecourse loan, the transactions is treated as a sale in its entirety.(2) Thus, in Example 1, if the loan had been nonrecourse (i.e., if B had not retained personal liability on the debt). B would have realized a $35,000 loss, and would have recognized no income from the discharge of indebtedness.

The difference in the tax consequences of foreclosure on recourse and nonrecourse loans is significant because it establishes the principle that forgiveness of a nonrecourse debt does not trigger forgiveness of indebtedness income. This principle is based on the freeing of assets doctrine: cancellation of indebtedness income (CODI) is recognized for tax purpose only to the extent that forgiveness of an existing debt increase the borrower's equity in remaining assets. Insolvent borrowers have no equity in their remaining assets, even after discharge of the indebtedness, and thus are excepted from income recognition by Sec. 108. Similarly, nonrecourse borrowers do not experience an increase in the equity value of their remaining assets on forgiveness of a nonrecourse loan because they never had personal responsibility for the loan; that is, their remaining assets were never encumbered by the debt.(3) The regulations under Sec. 1001 explicitly except these borrowers from the recognition of CODI when their nonrecourse loans are discharged. As discussed below, however this principle has been discarded in recent IRS pronouncements.

* Changes in the terms of a loan

As noted, one alternative to foreclosure is renegotiation of the terms of the debt. Given the large swing in market interest rates over the past decade, many debtors find themselves holding notes bearing interest at rates above current market levels. At the same time, the decline in real estate values makes foreclosure an unattractive options for many lenders. A better options may be for the lender to agree to lower the interest rate in exchange for a renewed commitment by the borrower to make payments on the loan.

The tax consequences of this type of transaction are relatively straightforward. The Service has taken the position that this transaction constitutes the exchange of one debt instrument for another(4). As such, it triggers CODI to the borrower under Sec. 108(e)(11)(10)(renumbered by the Revenue Reconciliation Act of 1993 (RRA)), and a bad debt deduction to the lender, but only to the extent that the imputed principal balance of the modified debt is less than the outstanding principal balance of the existing note. For debts not publicly traded, the present value, or imputed principal amount, of the modified obligation is determined under Sec. 1274 using the applicable Federal rate as of the date of the modification(5). Thus, so long as the modified note bears interest at a reasonable rate, no CODI should result from a mere modification in the rate of interest or other note term. When the "new" interest rate is below market, however, the transaction will be treated as if the borrower had satisfied the note at a discount. The tax consequences of such treatment are discussed later.

* Settlement at a discount - recourse debts

The tax consequences are much less clear when the lender and the borrower renegotiate the principal balance of an existing note in lieu of  foreclosure. Here, the outcome depends on whether the lender is the seller of the encumbered property, and whether the note is recourse or nonrecourse in nature.

When the note is not the result of a seller-financing transaction and is recourse in nature, reduction of the principal balance constitutes forgiveness of a portion of the debt, triggering CODI under Sec. 61(a)(12). Such income is taxable to the extent the borrower is solvent after the discharge. Sec. 108 allows deferral of income recognitions to the extent the borrower is insolvent(6).

Example 2: in 1990, B borrowed $250,000 on a recourse note from L. In 1993, when the outstanding principal balance of the note had fallen to $230,000, B satisfies the note with a payment of $150,000. After payment of the note, B's net worth is $25,000. Thus, applying the freeing of assets doctrine, satisfaction of the note has increased B's net worth by $25,000 (before repayment of the debt, B's assets were $150,000 higher and his liabilities were $230,000 higher; thus, his net worth was negative $55,000). Accordingly, B must recognize $25,000 in income from the discharge of indebtedness. The remaining $55,000 (total discharge was $80,000 [$230,000 principal balance - $150,000 settlement]) is deferred under Sec. 108 and must applied to reduce B's other tax attributes (net operating loss (NOL) and credit carryovers, etc.) or the basis of his remaining property.

* Settlement at a discount - nonrecourse debt

The Services has taken inconsistent positions on the appropriate tax treatment of discharged nonrecourse debt. As noted, the regulations under Sec. 1001 suggest quite strongly that CODI does not result from the forgiveness of nonrecourse debt?(7) The Service extended this principle to cases involving the reduction in debt outside of foreclosure transactions in Letter Ruling (TAM) 7953004(8) and in its arguments before the Tax Court in Gershkowitz(9). In Rev. Rul. 91-31,(10) however, it reversed its position, ruling that repayment of a nonrecourse debt at a discount will trigger CODI just as if the loan were recourse.

As noted above, the recognition of CODI has previously been based on the freeing of assets doctrine, which does not apply to the relief of nonrecourse liabilities (unless the value of the encumbered property exceeds the balance of the nonrecourse loan). Rev. Rul. 91-31 thus marks the first attempt by the Service to trigger CODI in these situations. As will be discussed below, a flurry of ruling issued at the end of 1992 suggests that the Service still has not fully come to grips with this position.

* Seller financing

When forgiven debt is seller-financed, Sec. 108(e)(5) creates a second exception to the requirements that CODI be recognized.(11) Under this provision, the borrower is allowed to treat the reduction as a purchase price adjustment, offsetting the debit entry to the loan account (writing off the forgiven portion of the debt) with a credit entry to the underlying assets (reducing basis in the encumbered property to reflect the debt reduction).

This exception was created in order to "eliminate disagreements between the Internal Revenue Services and the debtor as to whether, in a particular case to which the provision applies, the debt reductions should be treated as discharge income or a true price adjustment."(12) The provision applies only if the debtor is solvent(13), and if the seller remains the holder of the debt instrument(14).

This exception presumably reflects recognition that, in many such cases, the buyer will argue that the seller failed to reveal, or misrepresented, material facts during the process of negotiating the original purchase price. If the buyer's arguments is successful, the seller will have no recourse against the buyer personally; the seller is faced with the options of either taking the property back (voiding the sale) or agreeing to the new terms. Thus, there has been no freeing of additional assets to the borrower (because the seller has no additional recourse against the buyer) and there should be not recognition of income. The same is true when a nonrecourse liability is reduced by agreement between the borrower and the lender, and the same tax result should apply.

Of course, Rev. Rul. 91-31 explicitly rejected this position for nonrecourse debt reductions, in essence providing that all debt reductions should be treated the same, whether involving recourse or nonrecourse debt. Rev. Rul. 92-99(15) provided a limited exception to this position, allowing treatment as a purchase price adjustment for a reduction in indebtedness attributable to "infirmities" associated with the original sale (fraud or misrepresentation of a material fact). In all other cases involving third-party debts, Rev. Rul. 92-99, like Rev. Rul. 91-31, requires that solvent debtors recognize CODI.(16)

This exception is not based on any coherent logical framework, and thus serves only to highlight the conceptual difficulty of the position taken in Rev. Rul. 91-31. In fact, the exception for reduction of third-party nonrecourse loans in these narrow circumstances flatly contradicts the explanation provided by the Services for its refusal to allow purchase price adjustment treatment (i.e., basis reduction) for negotiated reduction in nonrecourse debt balances in other situations.(17)

The Service defends its position in transactions not involving infirmities associated with the original sale on the grounds that third-party lenders were not participants in the original sales transactions. Since the same is true same is true whether the reduction is due to an infirmity in the original sales transaction or not, it is clear how the Service can justify this exception. Logically, one can defend either the position taken by the Service with regard to nonrecourse debt reductions when the original transfer was tainted by an infirmity or its position on all other nonrecourse debt reductions, but no both. As noted, the historical rationale underlying the recognition of income from the discharge of indebtedness appears to support the position that the reduction of a nonrecourse liability as the result of negotiations between the lender and the borrower should always be treated as a purchase price adjustment, whether the reduction is due to an infirmity in the original sales transaction or not.

RRA Relief for Real Estate Debtors

This debate has been resolved legislatively for qualified real estate debtors. For tax years ending after 1992,(18) the RRA provides that debtors may elect to exclude CODI from the discharge of "qualified real property business indebtedness." The new exemption, which does not apply to C corporation debtors, allow debtors to defer recognition of qualifying CODI by reducing their basis in any remaining depreciable real property.(19)

The amount of the exclusion may not exceed the excess of the predischarge indebtedness over the FMV of the property encumbered by such debt (reduced by any other qualified real property business indebtedness), not may it exceed the debtor-taxpayer's aggregate predischarge basis in depreciable realty eligible for the reduction. For this purpose, depreciable realty acquired in anticipation of the discharge is not eligible for basis reduction. To the extent that the amount of the discharged debt exceeds either of these amounts, CODI must be recognized by the debtor.(20)

Example 3: J, a solvent individual, owns depreciable real estate used in his trade or business with an FMV of $150,000. J's basis in the depreciable real estate is $100,000. The real estate is encumbered by a first mortgage of $110,000 and a second mortgage of $90,000. In July 1993, the second mortgage agrees to reduce the second mortgage to $30,000, triggering $60,000 of CODI to J. If J so elects, he can defer $50,000 of the CODI under new Sec. 108(a)(1)(D) by reducing his basis in the encumbered realty to $50,000. J can defer only $50,000 of the $60,000 CODI, because the second mortgage exceeds the net value of the realty ($15,000 gross value of the property - the first mortgage of $110,000) by $50,000 ($90,000 second mortgage - the $40,000 net value of the property as determined above). Thus, J must recognize $10,000 of CODI as a result of this transaction.

* Qualified real property business indebtedness

The new exemption applies only to the discharge of qualified real property. To be eligible, the discharged debt must have been incurred or assumed by the debtor in connection with real property used in a trade or business, and must be secured by such property.(21) More restrictive requirements apply to debts in incurred after Dec. 31, 1992. Debts incurred after that date are not qualified unless incurred or assumed to finance the acquisition, construction, reconstruction or substantial improvement of realty used in a trade or business.(22) Debts incurred to refinance pre-1993 indebtedness are subject to the less restrictive requirements, but only to the extent the new obligation does not exceed the principal amount of the debt being refinanced.

* Subsequent disposition of property

CODI deferred under the new exemption for real estate loans is subject to the recapture provisions of Sec. 1250. However, only the portion of the deferred income that has not been indirectly recognized in the form of reduced depreciation deductions will be recaptured. Recapture is assured by treating the reduction in basis under new Sec. 108(c) as an accelerated depreciation deduction. Total depreciation, including the basis reduction, is then compared to the amount that would have been allowed using the straight-line method had there been no basis reduction. Thus, to the extent that the basis reduction reduces the debtor's depreciation allowance over time, the recapture potential is reduced.

Example 4: Q purchased an apartment complex in 1987. The original cost of the apartments was $650,000. In January 1992, when the FMV of the apartments complex had declined to $400,000, Q negotiated with her creditors to reduced the outstanding principal balance of the mortgage encumbering the complex from $500,000 to $400,000. Her remaining basis in the apartment complex at that date was $531,820 (computed using straight-line depreciation over 27.5 years). Q elected to defer recognition of the $100,000 CODI by reducing her basis in the apartment complex to $431,820. As a result of the reduction in basis, depreciation of the apartment complex will generate deductions of only $19,192 per year ($431,820 [divided by] the remaining depreciable life of 22.5 years). Q sells the apartment complex in January 1994 for $525,000. Her remaining basis at that date will be $393,436 ($431,820 - $38,384 depreciation expense). Thus, she will recognize a gain of $131,564 ($525,000 - $393,436). For purposes of Sec. 1250, Q will be deemed to have taken depreciation deductions of $256,564 ($650,000 - $393,436). The amount she would have been allowed under the straight-line method, $165,455 ($650,000 [divided by] 27.5 x 7 years), is determined as if the basis reduction under Sec. 108 had not been made. Thus, of Q's $131,564 gain on sale of the apartments, $91,109 ($256,564 - $165,455) will be recaptured as ordinary income under Sec. 1250.

Special Problems for Partnerships

Troubled debt transaction take on an additional layer of uncertainty when the debtor is a partnership rather than an individual taxpayer. In addition to the questions of whether and how much CODI should be recognized, additional uncertainties arise as to who should recognize the CODI, when it should be recognized and how it should be allocated among the partners. Moreover, the possibility that the partnership may satisfy the obligation by transferring equity interest in the partnership to the lender raises additional questions about the amount, if any, of CODI that should be recognized.

* Who recognizes CODI?

The uncertainty as to who should recognize CODI when partnership debts are forgiven is based on Sec. 108(d)(6), which provides that the insolvency exception to Sec. 61(a)(12) is to be applied at the partner, rather than the partnership, level. This provision, in turn, is based on state law, which provides that general partners are individually liable for partnership recourse debts. Since a partnership's creditors have recourse against individual partners, it is ultimately the partners, and not the partnership, who are forgiven by the creditors, at least with regard to recourse loans. Thus, the insolvency exception is appropriately applied at the partner level, It would seem appropriate to trigger CODI at the individual partner level as well.

This approach would be compatible with the Sec. 752 rules governing changes on partnership liabilities. The release by creditors of the partnership from responsibility for partnership debt would trigger a deemed distribution to the partners under Sec. 752(b). However, since the individual partners would then have personal responsibility for those debts, this deemed distribution would be accompanied by a deemed contribution under Sec. 752(a). Thus, no gains should be triggered under Sec. 731(a) (as the result of excess distributions), and income would be recognized only once - at the individual partner level, when the liabilities are acttually forgiven.(23)

Although Sec. 752 provides a well-reasoned framework for such an analysis, the Service has chosen to forgo this approach. Instead, in Rev. Rul. 92-97,(24) it has treated CODI as a partnership level item, while continuing to apply Sec. 108 at the individual partner level. This raises two questions: First, how is CODI to be allocated among the partners? Second, when is CODI recognized?

Allocation of CODI

Treating CODI as a partnership level item creates the potential for double taxation of income if the allocation CODI does not follow the allocation of the underlying debt. The problem arises because, unlike the approach in which the deemed Sec. 752(b) distribution associated with the forgiveness is offset by a deemed Sec. 752(a) contribution, when CODI is a partnership level item, the Sec. 752(b) distribution is offset only by the allocation of partnership CODI. Thus, if the deemed Sec. 752(b) distribution to an individual partner exceeds his allocable share of partnership CODI, an additional gain under Sec. 731(a) may be triggered.

Example 5: In 1992, A and B formed the AB partnership with cash contributions of $10,000 and $90,000 respectively. AB then borrowed $900,000 from an unrelated lender and purchased property from an unrelated seller for $1,000,000. The partnership agreement allocates losses 10% to A and 90% to B, but profits are allocated equally. Thus, under Sec. 752, the $900,000 liability is allocated $90,000 to A (giving her an initial basis in her partnership interest of ($100,000) and $810,000 to B (resulting in a basis of $900,000 in B's partnership interest).

At the end of five years, the partnership's net losses total $1,000,000, of which $100,000 has been allocated to A and $900,000 to B, leaving the partners with zero bases in their partnership interests. In year 6, the creditor canceled the partnership's $900,000 debt, thus triggering $900,000 of CODI at the partnership level, which is allocated $450,000 to each partner in accordance with the partnership agreement. In addition, cancellation of the debt triggers a deemed distribution of $90,000 to A (her share of the partnership's liability) and $810,000 to B. A's deemed distribution of $90,000 is offset by her $450,000 share of partnership CODI, leaving her with a tax basis in her partnership interest (and capital account) of $360,000. B's deemed distribution, however, is $810,000. After adjusting his basis for his $450,000 share of partnership CODI, the reduction in partnership liabilities results in an excess distribution of $360,000 to B, triggering income in the same amount under Sec. 731(a). Thus, in addition to the $900,000 of CODI recognized by A and B, another $360,000 (presumably capital gain) is recognized by B under Sec. 731(a).

Rev. Rul. 92-97 allows partnerships to allocate CODI from recourse debts in any way they see fit as long as the deficit restoration requirement of Sec. 704(b) is satisfied; that is, as long as the partnership agreement requires that partners restore deficits in their capital accounts on liquidation.(25) This position raises problems for both partners and the Service.

Allocating CODI differently from the allocation of the underlying debt can be very expensive for the unwary partner. A partner whose Sec. 752 debt allocation exceeds his allocable share of partnership CODI may not only recognize additional income under Sec. 731 (as illustrated above), he may also be required to restore the resulting deficit in his capital account. In Example 5, for instance, B will not only recognize an additional $360,000 gain under Sec. 731(a) (resulting in a total of $810,000 recognized income to B), he will also be required to make a $360,000 payment to the partnership (the deficit balance in his capital account is $360,000 ($90,000 contributed - $900,000 allocable share of partnership losses + $450,000 allocable share of partnership CODI)). Since the partnership agreement is a binding contract with the other partners, he very likely will be unable to avoid this obligation.(26) This is clearly a disastrous turn of events for B.

The position taken by the Service in Rev. Rul. 92-97 is also questionable from a conceptual perspective. Although on its face the analysis appears consistent with Sec. 704(b) - the CODI allocations are allowed to differ from the debt allocations only if the partnership agreement obligates partners to restore deficits - the underlying premise of Sec. 704(b) is that partnership allocations should mirror economic reality. It seems clear that in Example 5, either the Sec. 752 allocation of the partnership's debts or the Sec. 704(b) allocation of its CODI is economic fiction. In any event, the ruling presents a potentially huge trap for the unwary (or unsophisticated) partner.

* Timing of partnership CODI

The second issue arising from the decision to treat CODI as a partnership level item concerns the timing of income recognition for the partners. Even ignoring situations in which the allocation of CODI does not follow the allocation of the underlying debts, the partners are faced with two sources of income recognition: the recognition of their portions of the partnership's CODI and the potential for income recognition under Sec. 731(a), if the "deemed" distributions associated with the decrease in liabilities exceed their bases in their partnership interests. Generally, if the CODI and the deemed distributions are treated as occurring together (and the CODI allocations follow the allocation of the underlying liabilities), the CODI allocations will increase the partners' bases by a sufficient amount to prevent income from being triggered under Sec. 731(a). If the deemed distributions associated with cancellation of the partnership's debt are treated as occurring before the recognition of CODI, however, double taxation of income could result.

Rev. Rul. 92-97 provided that the deemed distributions under Sec. 752(b) will be treated as draws against the partners' shares of partnership CODI, thereby alleviating any concerns over timing. The Service has also indicated a willingness in its public comments to apply the same treatment to forgiveness transactions involving partnership nonrecourse debts.(27) It would be difficult to conceive of a defensible rationale for treating nonrecourse debtors otherwise so long as the Service continues to follow Rev. Rul. 91-31.(28)

Discharge of Qualified Real Property

Indebtedness Held by a Partnership

The application of the exemption for discharge of qualified real estate loans held by a partnership is rather complex. First, consistent with the previous discussion, the election to exclude CODI arising from the discharge is to be made at the partner level, rather than by the partnership.(29) This is true even though the determination of whether the discharged debt is a qualified real property business loan clearly must be made at the partnership level.(30)

More interesting are the consequences to the partners of making the election. As noted previously, the election allows the partner-debtor to defer CODI by reducing his basis in depreciable realty. Although the basis of any depreciable realty held by the debtor may be reduced under the statute, the most likely target for basis reduction will generally be the property securing the discharged indebtedness. This could pose a problem for many partners since they do not directly own this property, and may not own any other depreciable realty. Recognizing this potential problem, the new law treats the partners' partnership interests as depreciable real property, thus allowing them to defer recognition of the CODI by decreasing their bases in their partnership interests.

Example 6: A is one-third partner in the ABC partnership. In 1993, ABC negotiated with its lender to reduce the outstanding balance of a mortgage on qualified real property held by the partnership from $195,000 to 105,000. The discharge triggers $90,000 of CODI at the partnership level. This income is allocated equally among the partners. Before the discharge, A's basis in his partnership interest was $80,000 ($15,000 of net contributions to capital + his $65,000 share (one-third) of partnership debt). The allocation of CODI to A will increase his basis in his partnership interest to $110,000. At the same time, however, the reduction in A's share of partnership liabilities will be treated as a distribution of cash under Sec. 752, reducing his basis in his interest back to $80,000. If A elects to exclude his $30,000 share of partnership CODI under Sec. 108, he will be required to reduce his basis in his partnership interest by a corresponding amount. A's basis in his partnership interest after the reduction of the principal balance of the mortgage will thus be $50,000.

The RRA committee reports suggested that any decreases in a partners's basis in his partnership interest under Sec. 108 flow up to the partnership, resulting in a corresponding decrease in the partnership's basis in partnership depreciable realty. Moreover, this decrease is to be made with respect to the electing partner only.(31) Thus, in Example 6, assuming only partners A and B elected to exclude their shares of the partnership CODI, the partnership would be required to reduce its basis in depreciable realty by $60,000. This decrease would be made with respect to A's and B's shares of the realty only, so that C would receive a larger allocation of depreciation expense, and a smaller share of any gain from the property's disposition. This adjustment would be similar in nature to basis adjustments under Sec. 734(b) or 743(b), although it does not appear that the partnership can avoid adjustments under Sec. 108 merely by refusing to make (or revoking) an election under Sec. 754.(32) Although perhaps necessary to ensure that the new Sec. 108 exclusion works merely to defer (rather than eliminate) CODI, this basis adjustment mechanism will result in significant new recordkeeping complexities for many partnerships.

Exchange of Debt for a Partnership Interest

In many cases, a preferable alternative to foreclosure, or satisfaction at a discount, may be to accept an equity interest in the debtor partnership in satisfaction of the debt. The tax treatment of such a transaction is uncertain, and the Service reportedly has not decided how it should be treated.(33) The issue essentially boils down to whether Sec. 721 (governing contributions of property to partnerships) or Sec. 61(a)(12) (requiring recognition of CODI) should apply.

As a practical matter, it seems that the principles of Sec. 108(e)(7) and (e)(8) should apply. Sec. 108(e)(7) governs the tax consequences to lenders receiving corporate stock in satisfaction of loans. The creditor is allowed a bad debt deduction to the extent the outstanding debt exceeds the value of the stock received. The stock is then classified as Sec. 1245 property so that any subsequent gain on disposition is recaptured as ordinary income to the extent of the bad debt deduction previously taken.

Sec. 108(e)(8) governs the tax consequences to corporate debtors in these situations. When a corporation transfers stock to a creditor in satisfaction of a debt, the corporate debtor will be treated as having satisfied the debt with a cash payment equal to the value of the transferred stock. Thus, the corporation is treated as having issued its stock for cash which, in turn, is used to pay off the debt. CODI is recognized only to the extent the outstanding debt exceeds the deemed cash payment (i.e., the stock's FMV).

Although the circumstances are perhaps altered slightly when the debtor is a partnership (because the debts involved are ultimately those of the partners rather than of the partnership itself), it seems that the same principles should apply. In fact, Sec. 108(e)(7)(E) specifically requires the application of "similar" rules to creditors receiving partnership equity interests in payment of outstanding loans. The principles of new Sec. 108(e)(10) should likewise apply.

Following these principles, satisfaction of a partnership's debt in exchange for an equity interest in the partnership should be treated as a cash contribution by the lender to the partnership in an amount equal to the value of the partnership interest received, with the deemed cash contribution then being used to satisfy the debt. This gives the creditor an FMV basis in the partnership interest received in the first step, and a bad debt deduction equal to the amount of the excess debt "forgiven" in the second step. The partnership, on the other hand, recognizes CODI in an amount equal to the creditor's bad debt deduction. This CODI is allocated to the original partners under Sec. 704(c). The final step in the transaction involves writing the debt off the partnership's books, which may trigger additional income to the original partners under Sec. 731(a).

Example 7: The AB partnership had the following balance sheet on Dec. 31, 1992:

              Basis    FMV
Assets        $100    $450

Liabilities     300    300
Capital, A     (100)    75
Capital, B     (100)    75
               $100   $450

A and B are equal partners; each has a basis in his partnership interest of $50 ($150 share of debt - $100 deficit in capital). On Dec. 31, 1992, AB's lender accepted a one-third interest in the partnership in satisfaction of the debt. The one-third interest is valued at $150.

The transaction will affect A and B in two ways. First, because the lender forgave $300 of debt in exchange for a deemed cash payment of $150, AB must recognize $150 of CODI. Allocated equally between A and B, this increases their tax capital accounts by $75 (to ($25) each). Second, the elimination of AB's $300 debt is treated under Sec. 752(b) as a distribution of $150 to each partners. Since A and B had bases in their partnership interests immediately before the deemed distributions of $125 each ($50 initial basis + $75 share of CODI), each partner will recognize an additional $25 capital gain under Sec. 731(a) as a result of the excess distribution. (If the partnership has a Sec. 754 election in effect, the partnership will be entitled to increase its basis in its assets by $50 to account for the Sec 731(a) gains.) The lender will be entitled to a $150 bad debt deduction, and will take a basis of $150 in its partnership interest.

Conclusion

One result of the decline in real estate markets has been an increased volume of troubled debt transaction. The Service has issued a number of rulings to provide advice in this area. In many respects, the rulings are contradictory, either with one another or with existing principles drawn from the Code and regulations. Although the Revenue Reconciliation Act of 1993 has provided significant relief for individual debtors in the real estate industry, taxpayers and their advisers need to be careful to recognize and avoid the adverse tax consequences that may accompany many debt restructurings, particularly those involving partnership liabilities.

(1) Regs. Sec. 1.1001-2(a)(1) and (2) and -2(c), Example (8). (2) See Regs. 1.1001-2(c), Example (7). (3) A strong arguments can be made that since nonrecourse liabilities do not affect equity, they should not be allowed to increase asset basis. This is, in fact, the presumption behind the "at risk" limitations of Sec. 465. Unfortunately, Sec. 465 has never applied to most real estate activities, leaving the Service with the difficult task of constructing an appropriate framework to address nonrecourse debt transactions. (4) Rev. Rul. 89-122, 1989-2 CB 200. Note that under proposed regulations, a reduction in the interest rate charged on a debt is treated as an exchange only if the modified rate varies from the original rate by more than one-quarter of a percentage point (Prop. Regs. Sec. 1.1001-3(e)(1)(i). (5) The imputed principal amount of a publicly traded debt obligation is determined under Sec. 1273, rather than Sec. 1274, and is generally deemed to equal the FMV of the original obligation before the modification (Sec. 1273(b)(3)). (6) Sec. 108(g) also allows deferral of income recognition on the discharge of "qualified farm indebtedness" (which will not be discussed in this article). In addition, new Sec. 108(a)(1)(D), added by the RRA, allows deferral of income recognition on the discharge of qualified real property business indebtedness (to be discussed in detail later on). (7) See Ricketts and McNally, "Discharge of Indebtedness," 21 The Tax Adviser 648 (Oct. 1990); Schmalz, Brumbaugh, Crnkovich and Jones, "IRS Insists That Reduction or Cancellation of Nonrecourse Debt Always Results in Income," 75 Journal of Taxation 68 (Aug. 1991); and Ricketts, "Discharged Indebtedness: Evaluating the Service's Position in Revenue Ruling 91-31," 9 Journal of Taxation of Investments 108 (Winter 1992), in which the author argued that the reduction in nonrecourse debt should be accounted for by reducing the debtor's basis in the encumbered asset, with income being recognized (under the tax benefit doctrine) only to the extent the decrease in nonrecourse debt exceeds the debtors' basis in the encumbered property. See also Vincent Stackhouse, 441 F2d 465 (5th Cir. 1971)(27 AFTR2d 71-1211, 71-1 USTC [paragraph]9352), in which the Fifth Circuit reached the same general conclusion. See also Virgil W. Moore, TC Memo 1987-499, decided simultaneously with Herbert Gershkowitz, 88 TC 984 (1987), in which the Tax Court was compelled to follow Stackhouse. (8) IRS Letter Ruling (TAM) 7953004 (9/7/79). (9) Gershkowitz, note 7. (10) Rev. Rul. 91-31, 1991-1 CB 19. (11) The first exception in Sec. 108(a)(1)(B), allowing deferral when the debtor is insolvent. (12) S. Rep. No. 96-1035, 96th Cong., 2d Sess. 16 (1980) (hereinafter, the "Senate Report"), and H. Rep. No. 96-833, 96th Cong., 2d Sess. 13 (1980). (13) Sec. 108(e)(5)(B). (14) See Senate Report, note 12, at 16. (15) Rev. Rul. 92-99, 1992-2 CB 35. (16) The exception for cases involving "infirmities" with the original sales transaction appears to contradict the committee reports (note 14), which explicitly deny the application of Sec. 108(e)(5) whenever the seller does not hold the debt instrument. (17) See also Rev. Rul. 92-53, 1992-2 CB 48, in which the Service ruled that the excess of nonrecourse debt over the encumbered property's FMV will not be considered for purpose of determining the debtor's insolvency, except to the extent that particular nonrecourse debt is discharged. This ruling is clearly based on the "freeing of assets" doctrine. See Lipton, "IRS Adopts Inconsistent Positions on Nonrecourse Debt in Loan Workouts," 77 Journal of Taxation 196 (Oct. 1992), for an excellent discussion of the conceptual inconsistency between this ruling and Rev. Rul. 91-31. (18) The debt discharge must also take place after Dec. 31, 1992 (RRA Section 13150(d)). (19) New Sec. 108(a)(1)(D) and (c)(1)(A), added by RRA Section 13150(a) and (b). (20) New Sec. 108(c)(2)(A). (21) New Sec. 108(c)(3)(A). (22) New Sec. 108(c)(4). (23) The IRS has announced its intention to allow a partner to look through the partnership and treat his individual share of partnership debt as a personal liability for purpose of determining the partner's individual solvency (BNA Daily Tax Report, No. 207, 10/26/92, at G-7). This position is consistent with the above framework. (24) Rev. Rul. 92-97, 1992-2 CB 124. (25) Nonrecourse CODI will trigger the minimum gain chargeback provisions required under the Sec. 704(b) regulations. Thus, it will presumably have to follow the allocation of the underlying nonrecourse debt (because that debt allocation follows the minimum gain allocation). (26) If B refuses (or is unable) to restore the deficit in his capital account, and the partnership does not enforce the obligation, does B recognize an additional $360,000 in CODI? The deficit restoration provision presumably creates a legal liability between B and the partnership. (27) See BNA Daily Tax Report, No. 216, 11/6/92, at G-1. (28) The Service's acknowledgment of a possible distinction between CODI from recourse debts and CODI from nonrecourse debts (which triggers minimum gain chargeback under Sec. 704(b)) indicates that it is still not fully accepted the rationale underlying Rev. Rul. 91-31. (29) Sec. 108(d)(6). (30) Note that the same scheme does no apply to S corporations. The election to exclude CODI from the discharge of a qualified real estate loan held by an S corporation is made at the corporate level, since S shareholders are theoretically not liable for corporate debts. Sec. 108(d)(7). (31) See the House Report accompanying RRA Section 13150. (32) This may still be an open issue. The stature itself does not directly address the consequences of the election by a partner to exclude CODI arising from discharge of partnership debts. Thus, it is not clear how the intentions expressed in the committee reports are to be enforced. (33) See BNA Daily Tax Report, No. 192, 10/2/92, at G-11 and No. 207, 10/26/92, at G-7. (1) Regs. Sec. 1.1001-2(a)(1) and (2) and -2(c), Example (8). (2) See Sec. 1.1001-2(c), Example (7). (3) A strong argument can be made that since nonrecourse liabilities do not affect equity, they should not be allowed to increase asset basis. This is, in fact, the presumption behind the "at risk" limitations of Sec. 465. Unfortunately, Sec. 465 has never applied to most real estate activities, leaving the Service with the difficult task of constructing an appropriate framework to address nonrecourse debt transactions. (4) Rev. Rul. 89-122, 1989-2 CB 200. Note that under proposed regulations, a reduction in the interest rate charged on a debt is treated as an exchange only if the modified rate varies from the original rate by more than one-quarter of a percentage point (Prop. Regs. Sec. 1.1001-3(e)(i)). (5) The imputed principal amount of a publicly traded debt obligation is determined under Sec. 1273, rather than Sec. 1274, and is generally deemed to equal the FMV of the original obligation before the modification (Sec. 1273(b)(3)). (6) Sec. 108(g) also allows deferral of income recognition on the discharge of "qualified farm indebtedness" (which will not be discussed in this article). In addition, new Sec. 108(a)(1)(D), added by the RRA, allows deferral of income recognition on the discharge of qualified real property business indebtedness (to be discussed in detail later on). (7) See Ricketts and McNally, "Discharge of Indebtedness," 21 The Tax Adviser 648 (Oct. 1990); Schmalz, Brumbaugh, Crnkovich and Jones, "IRS Insists That Reduction or Cancellation of Nonrecourse Debt Always Results in Income," 75 Journal of Taxation 68 (Aug. 1991); and Ricketts, "Discharged Indebtedness: Evaluating the Service's Position in Revenue Ruling 91-31," 9 Journal of Taxation of Investments 108 (Winter 1992), in which the author argued that the reduction in nonrecourse debt should be accounted for by reducing the debtor's basis in the encumbered asset, with income being recognized (under the tax benefit doctrine) only to the extent the decrease in nonrecourse debt exceeds the debtor's basis in the encumbered property. See also Vincent Stackhouse, 441 F2d 465 (5th Cir. 1971)(27 AFTR2d 71-1211, 71-1 USTC [paragraph]9352), in which the Fifth Circuit reached the same general conclusion. See also Virgil W. Moore, TC Memo 1987-499, decided simultaneously with Herbert Gershkowtiz, 88 TC 984 (1987), in which the Tax Court was compelled to follow Stackhouse. (8) IRS Letter Ruling (TAM) 7953004 (9/7/79). (9) Gershkowitz, note 7. (10) Rev. Rul. 91-31, 1991-1 CB 19. (11) The first exception is in Sec. 108(a)(1)(B), allowing deferral when the debtor is insolvent. (12) S. Rep. No. 96-1035, 96th Cong., 2d Sess. 16(1980) (hereinafter, the "Senate Report"), and H. Rep. No. 96-833, 96th Cong., 2d Sess. 13 (1980). (13) Sec. 108(e)(5)(B). (14) See Senate Report, note 12, at 16. (15) Rev. Rul. 92-99, 1992-2 CB 35. (16) The exception for cases involving "infirmities" with the original sales transaction appears to contradict the committee reports (note 14), which explicitly deny the application of Sec. 108(e)(5) whenever the seller does not hold the debt instrument. (17) See also Rev. Rul. 92-53, 1992-2 CB 48, in which the Service ruled that the excess of nonrecourse debt over the encumbered property's FMV will not be considered for purposes of determining the debtor's insolvency, except to the extent that particular nonrecourse debt is discharged. This ruling is clearly based on the "freeing of assets" doctrine. See Lipton, "IRS Adopts Inconsistent Positions on Nonrecourse Debt in Loan Workouts," 77 Journal of Taxation 196 (Oct. 1992), for an excellent discussion of the conceptual inconsistency between this ruling and Rev. Rul. 91-31. (18) The debt discharge must also take place after Dec. 31, 1992 (RRA Section 13150(d)). (19) New Sec. 108(a)(1)(D) and (c)(1)(A), added by RRA Section 13150(a) and (b). (20) New Sec. 108(c)(2)(A). (21) New Sec. 108(c)(3)(A). (22) New Sec. 108(c)(4). (23) The IRS has announced its intention to allow a partner to look through the partnership and treat his individual share of partnership debt as a personal liability for purposes of determining the partner's individual solvency (BNA Daily Tax Report, No. 207, 10/26/92, at G-7). This position is consistent with the above framework. (24) Rev. Rul. 92-97, 1992-2 CB 124. (25) Nonrecourse CODI will trigger the minimum gain chargeback provisions required under the Sec. 704(b) regulations. Thus, it will presumably have to follow the allocation of the underlying nonrecourse debt (because that debt allocation follows the minimum gain allocation). (26) If B refuses (or is unable) to restore the deficit in his capital account, and the partnership does not enforce the obligation, does B recognize an additional $360,000 in CODI? The deficit restoration provision presumably creates a legal liability between B and the partnership. (27) See BNA Daily Tax Report, No. 216, 11/6/92, at G-1. (28) The Service's acknowledgment of a possible distinction between CODI from recourse debts and CODI from nonrecourse debts (which triggers minimum gain chargeback under Sec. 704(b)) indicates that it still has not fully accepted the rationale underlying Rev. Rul. 91-31. (29) Sec. 108(d)(6). (30) Note that the same scheme does not apply to S corporations. The election to exclude CODI from the discharge of a qualified real estate loan held by an S corporation is made at the corporate rate level since S shareholders are theoretically not liable for corporate debts. Sec. 108(d)(7). (31) See the House Report accompanying RRA Section 13150. (32) This may still be an open issue. The statute itself does not directly address the consequences of the election by a partner to exclude CODI arising from discharge of partnership debts. Thus, it is not clear how the intentions expressed in the committee reports are to be enforced. (33) See BNA Daily Tax Report, No. 192, 10/2/92, at G-11, and No. 207, 10/26/92, at G-7.