Applying the sec. 108(c) basis adjustment election to foreclosures.
Sec. 108(a) provides a number of exceptions to COD income recognition. This article examines avoidance of COD income recognition under Sec. 108(a)(1)(D) and (c), which provide that a solvent non-C corporation debtor can exclude income arising from forgiveness of "qualified real property business indebtedness" (QRPBI); in return for the income exclusion, under Sec. 108(c), the taxpayer must reduce the basis of his depreciable real property.
Although the legislative history of Sec. 108(c) anticipates that the deferral of COD income will generally arise when the taxpayer continues to own the real proper on which the debt was discharged, Sec. 108(c) may also be used when the taxpayer disposes of the property giving rise to the COD income, even if in a foreclosure.
Consequences of Debt Relief
To the Borrower
In general, if a borrower pays less than the entire principal balance in full satisfaction of a loan to purchase real estate, he recognizes COD income equal to the excess of the loan balance due over the payment made.(1) In addition, under the Sec. 111 tax benefit rule, an accrual-basis borrower who claimed deductions in prior years for accrued but unpaid interest recognizes additional income to the extent such interest is discharged without payment; a cash-basis borrower who has not deducted unpaid interest will not recognize such income on the discharge of its interest payment obligation.(2)
COD Income is recognized regardless of whether the debt is recourse or nonrecourse.(3) If the secured property is surrendered to a lien creditor in exchange for the discharge of recourse debt, the transaction is bifurcated into the (1) gain or loss attributable to the disposition of the real property and (2) COD income, a two-step approach authorized in the regulations and adopted by most courts.(4) If the secured property is surrendered in satisfaction of nonrecourse debt, the gain or loss is treated as from the sale or exchange of the property.(5)
Example 1: X owns a building with an adjusted basis of $400,000 and FMV of $600,000 that is subject to an $800,000 mortgage held by L. If the debt is nonrecourse and L takes the property in satisfaction of the mortgage, X incurs a gain on disposition of $400,000 ($800,000 - $400,000).(6) If the debt is recourse, the transaction is bifurcated into the gain attributable to the transfer of the property, $200,000 ($600,000 - $400,000) and the COD income, $200,000 ($800,000 - $600,000).
To the Lender
The acceptance of no payment or of less than the entire outstanding principal balance in full satisfaction of a loan results in a bad debt deduction under Sec. 166(b) for the year the loan is canceled to the extent of the excess of the lender's adjusted basis in the loan over the payment received. In addition, an accrual-basis lender who has previously included in income accrued but unpaid interest has an additional deduction to the extent of such interest.(7)
Example 2: The facts are the same as in Example 1. L can claim a $200,000 bad debt deduction ($800,000 - $600,000).
While a corporate lender's bad debts are fully deductible against ordinary income under Sec. 166(a), a noncorporate lender may have either a business bad debt deduction (deductible under Sec. 166(b) against ordinary income) or a nonbusiness bad debt deduction (deductible under Sec. 166(d)(1)(B) as a short-term capital loss).(8)
COD Income Relief
Bankrupt or Insolvent Taxpayers
In certain circumstances, a borrower who pays back less than the entire outstanding principal balance of his debt will not recognize COD income. If the taxpayer is in title 11 bankruptcy at the time of the discharge, Sec. 108(1)(1)(A) excludes the COD income. If the discharge occurs when the borrower is merely "insolvent" (i.e., as defined by Sec. 108(d)(3), his liabilities exceed the FMV of his assets immediately before the discharge), COD income is excluded only to the extent of the insolvency.(9) In return for the exclusion, under Sec. 108(b)(2) the bankrupt or insolvent taxpayer must reduce his tax attributes in the following order:
1. Net operating losses (NOLs) for the tax year of the discharge and any NOL carryovers to such year. 2. General business credits for the tax year of the discharge and any credit carryovers to such year. 3. The amount of any minimum tax credit as of the tax year following the tax year of discharge. 4. Any net capital loss for the tax year of discharge and any capital loss carryover to such year under Sec. 1212. 5. The basis of the borrowers property.(10) 6. Passive activity loss (PAL) or credit carryovers from the tax year of the discharge. 7. Foreign tax credit carryovers to or from the tax year of the discharge.(11)
Sec. 108(a)(1)(D) excludes COD income of a non-C corporation solvent taxpayer if the debt discharged is QRPBI. Sec. 108(c)(3)(A) and (4) define QPPBI as debt incurred or assumed to acquire, construct, reconstruct or substantially improve real property used in a trade or business and secured by such real property. Secs. 108(c)(1) and 1017(a) require that the excluded COD income reduce the basis of the taxpayer's depreciable real property at the beginning of the tax year following the year of discharge.(12)
The Sec. 108(c)(1) approach of reducing or eliminating future tax benefits in return for COD income nonrecognition is similar to that adopted by the bankruptcy (Sec. 108(a)(1)(A) and insolvency (Sec. 108(a)(1)(B) exceptions, particularly when the debtor-taxpayer elects under Sec. 108(b)(5) to reduce first the depreciable bases in his property in lieu of reducing tax attributes under Sec. 108(b)(2). However, unlike the bankrupt cy and insolvency exceptions, the QRPBI exception requires only a reduction in the bases in the taxpayers depreciable real property, nothing more.(13) Thus, the election provides for deferral of COD income by reducing the availability of depreciation in later years or increasing the gain (or reducing the loss) if the property is later disposed of in a taxable transaction.(14)
Thus, the QRPBI election offers substantial relief to both real estate entrepreneurs looking to salvage a distressed project and to lending institutions that have no desire to acquire real estate via foreclosure.
Example 3: Individual A owns a budding used in his trade or business, with an adjusted basis of $200,000 and FMV of $800,000 that is subject to a $1,000,000 nonrecourse loan payable in full on Jan. 1, 1997. Recognizing the distressed nature of the property, both A and lender L are willing to renegotiate the principal of the loan down to $800,000, the FMV Absent the QRPBI exclusion, the $200,000 reduction in principal would result $200,000 of COD income to A. If L were instead to foreclose on the property, A would recognize an $800,000 capital gain ($1,000,000 - $200,000) on the deemed sale. In either event, A would recognize "phantom income" (i.e., taxable income with no corresponding cash flow). Sec. 108(c) allows A to reduce the debt to $800,000 without the recognition of $200,000 of COD income, but requires A to reduce his basis in the property by the amount excluded; thus, under the election, A's basis in the property would be reduced from $200,000 to zero.
Exclusion limits: While the QRPBI exception offers considerable planning opportunities, its scope is not unlimited. First, the amount OF COD income that may be excluded is limited by Sec. 108(c)(2)(A) to the excess (if any) of (1) the outstanding principal amount of the QPPBI immediately before the discharge over (2) the FMV of the real property encumbered by the QRPBI(16) less (3) the outstanding principal amount of any other QRPBI on the property. (See Exhibit 2 on page 41.)
A second limitation under Sec. 108(c)(2)(B) provides that the amount excluded cannot exceed the aggregate adjusted bases of the depreciable real property held by the taxpayer immediately before the discharge. For this purpose, basis is determined after any tax attribute reductions required under the bankruptcy or insolvency exclusion. Because the bases of die taxpayers depreciable properties are generally reduced as of the beginning of the tax year following the year of discharge, this limitation should be applied after reducing the bases of the depreciable properties for any depreciation in the year of discharge. Sec. 108(c)(2)(B) specifies that depreciable real property acquired by the taxpayer in contemplation of the discharge is not taken into account for this purpose.
Example 4:(17) Individual (who is neither in bankruptcy nor insolvent) owns a building with an FMV of $150,000 used in his trade or business, that is subject to a $110,000 first mortgage and a $900,000 second mortgage. J negotiates the reduction of the second mortgage to $30,000 resulting in $60,000 of COD income. J has sufficient aggregate basis in business real property to absorb the reduction. J can elect to exclude $50,000 of the COD income, as follows:
Debt before discharge $90,000 FMV of property $150,000 Other debt (110,000) 40,000 Excluded COD income $50,000
The remaining $10,000 of COD income is includible.
Example 5: If J's aggregate basis in depreciable real property was less than $50,000, the amount of excluded COD income would be limited to the depreciable basis.
Example 6: If J were in bankruptcy or insolvent, the QRPBI exclusion would not apply. In general, Sec. 108(a)(2) specifies that the bankruptcy and insolvency exclusions take precedence over the QPPBI exclusion.
Election requirement.. According to Regs. Sec. 1.108(c)-1(a), the taxpayer must affirmatively elect under Sec. 108(c)(3) to exclude COD income under the QRPBI exception. Under Regs. Sec. 1.108(c)-1(b), the election must be made on the taxpayer's return for the tax year in which the discharge occurs.
The election is made on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), and is revocable with IRS consent, according to Pegs. Sec. 1.108(c)-1(b) and (c).
Recapture of basis reduction: A Sec. 108(c) basis reduction defers recognition of the excluded COD income until the property with the reduced basis is sold or exchange. The legislative history(18) of Secs. 108(c) and 1017(d)(1) provides that the basis reduction is treated as a depreciation deduction for purposes of the Sec. 1250 recapture rules. For purposes of computing any recapture amount under Sec. 1250, the determination of what would have been the depreciation adjustment under the straight-line method is made as if there had been no basis reduction, consequently, the amount of the basis reduction recaptured as ordinary income is reduced over the time the taxpayer continues to hold the property, as the taxpayer forgoes depreciation deductions due to the basis reduction.(19)
Application to foreclosures: The legislative history(20) of Sec. 108(a)(1)(D) and (c) presumes that the QRPBI exclusion election will generally be made when the taxpayer retains the property on which the debt is discharged. However, the election is also available when the taxpayers property is foreclosed on by a lender in satisfaction of the debt. In the case of foreclosure, the legislative history provides that generally, deferral should not extend beyond the period that the taxpayer owns the property. Thus, although the legislative history, adopting the rule of Sec. 1017, generally calls for the Sec. 108(c) basis adjustment at the beginning of the tax year following the tax year in which the discharge occurs, it also provides that if the taxpayer disposes of real property (in the transaction that gave rise to the discharge or otherwise) prior to the first day of the next tax year, the reduction in basis of such property is made as of the time immediately before the disposition.(22)
Sec. 108(c) does not state how the basis reduction rule applies to the taxpayers property; Sec. 108(c)(1)(B) simply cross-references Sec. 1017. In turn, Sec. 1017(b)(1) directs that the basis reduction calculation is to be provided in regulations. However, when Congress enacted Sec. 108(c), it also added Sec. 1017(b)(3)(F)(i), to clarify that only the bases of depreciable real property are to be reduced as the result of any nonrecognition arising from the discharge of QRPBI.(23) Further, Congress also added Sec. 1017(b)(3)(F)(iii) to clarify that if property subject to a basis adjustment under Sec. 108(c) is sold during the tax year in which the discharge occurs, the basis reduction applies as of immediately before the exchange so as to increase any gain (or reduce any loss) on the disposition. Therefore, while the general rule of Sec. 1017(a) calls for the basis adjustment of Sec. 108(c) to be made as of the beginning of the year following the year of discharge, the adjustment must be made immediately before the discharge if any property to which the adjustment applies is disposed of prior to the beginning of that year.
Interaction of Foreclosure and
the QRPBI Exclusion Rules
In the absence of regulations clarifying and illustrating the Sec. 108(c) basis adjustment rules, the interaction of the foreclosure rules with the Sec. 108(a)(1)(D) QRPBI exclusion may enable a taxpayer to currently recognize a loss from the sale or exchange portion of the transaction, while avoiding recognition of COD income arising from the foreclosure.
Example 7: X (who is neither in bankruptcy nor insolvent) owns an office building with an adjusted basis of $1,000,000 and FMV of $800,000 that is subject to a $1,300,000 mortgage. X negotiates an arrangement with lender M under which X will transfer the property to M in return for a cancellation of the debt. If the debt is nonrecourse, X recognizes a $300,000 gain ($1,300,000 - $1,000,000). If the debt is recourse, X recognizes a $200,000 loss ($1,000,000 - $800,000) and $500,000 of COD income ($1,300,000 - $800,000).
Regardless of the amount and character of the COD income and/or capital gain resulting from the foreclosure, under Sec. 469(g), the surrender of the property will release any associated suspended PALs to offset against the taxpayer's gain. In addition, under Sec. 172, the debtor-taxpayer will be able to offset any NOL carryovers against the COD income. Finally, to the extent the foreclosure causes capital gain as well as COD income, the taxpayer may offset capital loss carryovers against the gain, under Sec. 1212.
However, under Sec. 108(a)(1)(D), as previously discussed, even though the sale income must be currently recognized, all or a portion of X's COD income may be excluded if the debt is QRPBI. If it is, the taxpayer can exclude the COD income in return for a reduction in the basis of his depreciable real property, in accordance with the ordering rules of Sec. 1017 and the regulations. Although the statute does not directly address this ordering, it appears that the reduction of basis under Sec. 108(c) is to be applied first to the taxpayer's basis in the depreciable real property that secured the debt discharged.
Example 8: The facts are the same as in Example 7. In lieu of recognizing $500,000 of COD income, X can elect to reduce its basis in the foreclosed property by $500,000 immediately before the disposition, as provided in Sec. 1017(b)(3)(F)(iii). X then recognizes a gain on the foreclosure as follows:
FMV $800,000 Basis $1,000,000 Sec. 108(c) adjustment (500,000) Gain 500,000 $300,000
Under Sec. 1017(d)(1)(B), the Sec. 108(c) $500,000 basis adjustment is treated as a depreciation deduction for purposes of characterizing the $300,000 gain under the Sec. 1250 recapture rules. In addition, under Sec. 1017(d)(2) the Sec. 108(c) adjustment is not treated as a depreciation adjustment under the straight-line method for purposes of calculating any Sec. 1250 recapture. Consequently, the $300,000 gain is ordinary income under the recapture rules.
In other cases, the aggregate basis limitation of Sec. 108(c)(2)(B) may curtail the amount of COD income that may be excluded when the adjusted basis of the foreclosed property, after being reduced by the discharged debt, is less than the COD income.
Example 9: X (who is neither in bankruptcy nor insolvent) owns a commercial building with an adjusted basis of $600,000 and FMV of $1,500,000 that is subject to a $2,000,000 recourse mortgage. X defaults on the loan and the lender forecloses. If X elects to exclude the $500,000 of COD income ($2,000,000 - $1,500,000), the basis adjustment is deemed made under Sec. 1017(b)(3)(F)(iii) immediately before the foreclosure and the gain on the disposition is as follows:
FMV $ 800,000 Basis $1,000,000 Sec. 108(c) adjustment (100,000) Gain 900,000 Capital loss $(100,000)
Sec. 108(c)(2)(B) limits the amount of excluded COD income to $100,000 Presumably, any recapture under Sec. 1250 is limited to the excluded COD income.
Finally, in still other cases, electing to avoid the recognition of COD income can result in the current recognition of only capital loss.
Example 10: The facts are the same as in Example 7, but the recourse debt is $900,000. Absent a Sec. 108(c) adjustment, X recognizes a $200,000 capital loss ($800,000 - $1,000,000) and $100,000 of COD income ($900,000 - $800,000). With the Sec. 108(c) adjustment, X recognizes zero COD income and $100,000 capital loss, computed as follows:
FMV $ 800,000 Basis $1,000,000 Sec. 108(c) adjustment (100,000) 900,000 Capital loss $(100,000)
Because the transaction results in a loss, no recharacterization of the gain as ordinary income under the recapture rules is necessary. Thus, at the cost of reducing its capital loss, X avoids recognizing ordinary income.
Although the QRPBI exclusion rules appear premised on the taxpayer continuing to own the property securing the debt forgiven, Sec. 108(c) and its legislative history also take into account the application of the rules to a property the taxpayer does not retain. The interaction of the sale or exchange portion and the COD portion of the transaction allows the taxpayer to recognize a current loss from the exchange while avoiding COD income recognition. Although the taxpayer must adjust its basis in the foreclosed property so that its gain is increased (or its loss is decreased) on foreclosure, this appears to be a reasonable price to pay to avoid the COD income. Thus, the QRPBI election can significantly affect the amount and character of the gain or loss on the foreclosure, when the sale portion of the transaction gives rise to a current deduction.
In short, the bifurcated tax treatment of the foreclosure, coupled with a Sec. 108(c) basis adjustment, can result in a tax benefit to a borrower when the sale or exchange portion of the transaction results in a current capital loss. A debtor having real property with an FMV below both adjusted basis and recourse debt should consider transferring the property to the creditor in a "friendly foreclosure" if the Sec. 108(c) exclusion is available, to avoid COD income recognition.
(1) Sec. 61(a)(12); see, e.g., Herbert Gershkowitz, 88 TC 984 (1987). (2) Although outside the scope of this article, other general exceptions to the inclusion of COD income include cancelled debts that would give rise to a deduction if paid (Sec. 108(e)(2)) and purchase-money debt reductions that are mere purchase price adjustments (Sec. 108(e)(5)). (3) Rev. Rul. 91-31, 1991-1 CB 19. (4) See Rev. Rul. 90-16, 1990-1 CB 12; Regs. Secs. 1.1001-2(a)(2) and (c), Example (8), and 1.1017-1(b)(5); Bar L Ranch, Inc. v. Phinney, 426 F2d 995 (5th Cir. 1970)(25 AFTR2d 70-1234, 70-1 USTC [para.]9399); Fifth Ave-Fourteenth St. Corp., 147 F2d 453 (2d Cir. 1945)(33 AFTR 692, 45-1 USTC [para.]9115); Julian S. Danenberg, 73 TC 370 (1979), acq. 1980-2 CB 1; Harry L. Bialock, 35 TC 649 (1961), acq. 1961-2 CB 4; Est. of W.R. Whitthorne, 44 BTA 1234 (1941), appeal dismissed, 148 F2d 825 (9th Cir. 1945); Thomas E. Bressi, Jr., TC Memo 1991-651. (5) See Frankel, "Real Estate Workouts - A Step-by-Step Analysis," N.Y.U. Proceedings of the 53rd Institute on Federal Taxation, reprinted in 11 Tax Management Real Estate Journal 229 (10/4/95). (6) The amount realized on the disposition of property subject to a nonrecourse debt will always at least equal the debt; see, e.g., J.F. Tufts, 461 US 300 (1983)(51 AFTR2D 83-1132, 83-1 USTC [para.]9328). (7) Lonny E. Adams, TC Memo 1990-478. (8) Sec. 166(d)(2) defines a "nonbusiness debt" as a debt other than one created or acquired in connection with the lender's trade or business; see C.L. Hunt, TC Memo 1989-335. (9) Sec. 108(a)(3); other exclusions outside the scope of this article apply to discharged qualified farm debt (Sec. 108(a)(1)(C)), student loans (Sec. 108(f)), purchase price adjustments (Sec. 108(e)(5)) and contributions to capital (Sec. 108(e)(6)). (10) The borrower may instead elect to reduce first the basis of depreciable property under Sec. 108(b)(5)(A); the reduction may not exceed the aggregate adjusted bases of depreciable property held by the borrower as of the beginning of the tax year following the year of discharge; see Secs. 108(b)(5)(B) and 1017(a). The particular depreciable properties the bases of which are to be reduced are determined under Regs. Sec. 1.1017-1; however, a borrower may have the bases of his properties adjusted in a different manner with IRS consent; see Regs. Sec. 1.1017-2(a) and e.g., IRS Letter Ruling 8926003 (1/30/89). (11) According to Sec. 108(b)(3), the reduction in the general business credit, minimum tax credit, passive activity credit carryover and foreign tax credit carryover is 33 1/3 cents for each dollar of excluded COD income. (12) Regs. Sec. 1.1017-1 provides the basis-reduction ordering rules. Generally, the basis of specific purchased property for which the discharged debt was incurred is reduced first. The basis of other property is reduced. See "ABA Comments on Qualified Real Property Business Indebtedness Exception," Highlights and Documents (Tax Analysts, 9/9/94), p. 3592. (13) According to Sec. 108(b)(5)(C), Sec. 108 attribute reduction does not apply to COD income to which a Sec. 108(b)(5) election applies. (14) See Law and Mathena, "Qualified Real Property Business Indebtedness: Emerging Issues Under Sec. 108(c)," 11 Tax Management Real Estate Journal 127 (7/5/95). (15) Sec. 108(c)(2)(A) leaves unanswered whether unpaid interest at the time of the discharge may be included in the limitation calculation. If the debtor-taxpayer uses the accrual method, such unpaid interest must be added to the liability and is part of the outstanding principal amount. On the other hand Sec. 108(e)(2) makes clear that for all Code purposes, the discharge of debt, the payment of which would give rise to a deduction, is not COD income. This rule implies that the accrued and unpaid interest should not be added to the outstanding principal amount in calculating the limitation if the actual payment of the interest by the debtor-taxpayer would be a deductible trade or business expense. See "D.C. Bar Tax Section Comments on Cancellation of Qualified Real Property Business Indebtedness," Highlights and Documents (Tax Analysts, 8/12/94), pp. 2284-2285. (16) For the limitation to have meaning, FMV for this purpose cannot have the meaning in Sec. 7701(g), which provides that for purposes of subtitle A, FMV cannot be less than any nonrecourse debt on the property. (17) See H. Rep. No. 103-11, 103d Cong., 1st Sess. (WMCP, 1993) , p. 185. (18) Id., p. 187 (19) Id.; Sec. 1017(d)(2). (20) See H. Rep. No. 103-11, note 17, p. 185. (21) Id. (22) Id., p. 186; see Sec. 1017(b)(3)(F)(iii). (23) Generally, Sec. 1017(b)(3)(E) permits to treat inventoried real property as depreciable real property when the taxpayer has made an election under Sec. 108(b)(5) to reduce first the bases of depreciables assets before reducing other tax attributes under the normal ordering rule of Sec. 108(b); however, a taxpayer making the basis adjustment under Sec. 108(c) may not treat inventory as depreciable real property (Sec. 1017(b)(3)(F)(ii)).
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|Author:||Greene, Richard L.|
|Publication:||The Tax Adviser|
|Date:||Jan 1, 1997|
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