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Debt cancellation treatment clarified.

In Rev. Rul. 91-31, the IRS ruled that a reduction in the principal amount of an undersecured non-recourse debt by the creditor (who was not the seller of the property securing the debt) resulted in cancellation of indebtedness (COD) income to the debtor to the extent of the debt discharged. In the ruling, A, an individual, borrowed $1 million from C in order to purchase a $1 million office building from B. A's debt was nonrecourse and was secured by the office building. Later, when the building's value declined to $800,000, C agreed to reduce the note's principal amount from $1 million to $800,000, while leaving A in possession of the building.

Under similar circumstances, the Board of Tax Appeals (in Fulton Gold Corp., 31 BTA 519 (1934)) held that the discharge of a nonrecourse debt secured by property retained by the debtor should be treated as a reduction in the property's basis. In Rev. Rul. 82-202, the IRS implicitly rejected Fulton Gold, at least when the fair market value (FMV) of the secured property exceeded the debt. In that ruling, the taxpayer prepaid a nonrecourse mortgage owed to a third-party lender for an amount less than the mortgage's principal balance. The prepayment occurred at a time when the collateral's FMV exceeded the balance of the mortgage. The Service held that the taxpayer realized COD income equal to the difference between the principal amount paid and the mortgage balance. After this ruling, the holding of Fulton Gold arguably was limited, if it applied at all, to situations in which the value of the security was less than the amount of the debt.

Relying in part on Gershkowitz, 88 TC 984 (1987), the IRS indicated in Rev. Rul. 91-31 that it would not follow Fulton Gold, even when the indebtedness exceeded the property's value. In Gershkowitz, the court held that the settlement of a $250,000 nonrecourse debt by the debtor for a $40,000 cash payment resulted in $210,000 of COD income. The debtor retained possession of the property securing the debt, which at that time had an FMV of $2,500. In reaching its conclusion, the Tax Court, relying on the Supreme Court's decision in Tufts, 461 US 300 (1983), rejected the taxpayer's argument that the amount of COD income should be limited to the value of the collateral retained (since that amount represented the extent to which the taxpayer's assets were "freed up" by the discharge). The court emphasized that the Supreme Court held that discharging a nonrecourse obligation by conveying the collateral to the creditor results in the debtor's realization of a benefit equal to the full amount of the debt discharged, even when the value of the collateral is less than the amount of the debt. Consequently, in Rev. Rul. 91-31, the IRS concluded that A realized $200,000 of COD income, equal to the reduction in the nonrecourse debt owed to C from $1 million to $800,000.

After Rev. Rul. 91-31 and Gershkowitz, taxpayers seeking relief from nonrecourse indebtedness must carefully evaluate their options. For example, an insolvent or bankrupt taxpayer should consider renegotiating the debt or satisfying it with a reduced cash payment, since all or a portion of the amount discharged is eligible for exclusion from gross income under Sec. 108(a); on the other hand, if the bankrupt or insolvent debtor reconveys the property in satisfaction of the debt, the transaction would be treated as a sale, with no Sec. 108 exclusion available.

If the debtor is solvent, income realized from a discharged debt may still escape taxation, if the obligation is purchase-money indebtedness still held by the original seller of the property and the other requirements of Sec. 108(e)(5) are satisfied. If Sec. 108(e)(5) relief is unavailable, the debtor may consider taking advantage of the tax rate limitation on capital gains (usually a 3% savings) by conveying the pledged collateral in satisfaction of the debt.
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Author:Chmiel, Dean R.
Publication:The Tax Adviser
Date:Dec 1, 1991
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