REAL ESTATE PARTNERSHIP WORKOUTS

By Karrie L. Bercik, JD, LLM

I. Goals of Tax Planning.

The two goals of tax planning in a debt restructuring are to minimize recognition of income from cancellation of indebtedness ("COD income") and to maximize the use of tax attributes, such as net operating losses ("NOLs") and basis, after the restructuring.

II. Foreclosure or Transfer by Deed in Lieu of Foreclosure

It is well settled that a voluntary disposition of property through a deed in lieu of foreclosure or an involuntary disposition of property through foreclosure constitutes a sale or exchange for federal income tax purposes.1 Section 1001(a) provides that gain or loss recognized to a taxpayer in connection with the sale or disposition of property is measured by the difference between the amount realized and the adjusted basis of the property. Section 1001(b) defines the amount realized from the sale or other disposition of property as the sum of any money received plus the fair market value of other property received. The amount realized on a foreclosure or deed in lieu of foreclosure depends upon several factors, the most important of which are (1) whether the debt encumbering the property constitutes recourse or nonrecourse debt, and (2) the current fair market value of the property.

A. Nonrecourse Debt.

The amount realized upon the disposition of property subject to a nonrecourse debt will always be at least equal to the amount of the nonrecourse liability.2 Thus, if property subject to a nonrecourse debt is conveyed to the creditor, the debtor will recognize gain or loss equal to the difference between the amount of the liability discharged (plus the amount of cash and fair market value of any property paid to the debtor) and the debtor's adjusted tax basis in the property immediately before the disposition. No portion of the debtor's gain is treated as cancellation of indebtedness income ("COD"). Further, the property's fair market value is irrelevant to the transaction.

B. Recourse Debt.

If property subject to a recourse debt is conveyed to a creditor, the transaction is split into two parts.3 The two parts consists of (1) a taxable disposition of the property, and (2) to the extent the value of the property is less than the recourse liability, either a continuing debt obligation to the creditor or a discharge of the remainder of the liability. Under this approach, the taxpayer recognizes gain or loss equal to the difference between the fair market value of the property and the taxpayer's adjusted tax basis therein immediately prior to the disposition. If the remainder of the debt is forgiven, the amount forgiven will constitute COD income that, unless excepted under Section 108, will be included in the taxpayer's ordinary gross income.4

C. Partially Recourse Debt.

If the debt is partially recourse, the Service takes the position that a transfer of the property to the creditor will be allocated first to the nonrecourse portion of the debt in the absence of an agreement to the contrary.5 Thus, if the value of the property transferred to the creditor is less than the nonrecourse portion of the debt, the amount realized by the debtor will equal the nonrecourse portion of the debt and the recourse portion will constitute COD under Treas. Reg. § 1.1001-2(c), Examples (7) and (8).

D. Partnership Recourse debt.

Under Section 752, a partnership nonrecourse debt that is partially secured by partner guarantees that are limited in amount is treated as a recourse debt to the extent of the guaranteed amount. The question becomes does Section 752 control in determining whether the debt is recourse for purposes of determining gain, loss, and COD income on foreclosure? There is no authority on point discussing whether the debt should be treated as recourse or nonrecourse to the extent of a partner guarantee for purposes of determining gain or loss. However, the Service has suggested that it will follow Section 752 recourse definitions in determining whether a debt is recourse or nonrecourse.6 Thus, if a partner bears the economic risk of loss (as defined in Treas. Reg. § 1.752-2) the indebtedness will be treated as recourse indebtedness.

III. Cancellation of Indebtedness.

A. General Rule.

As a general rule, cancellation of indebtedness produces income equal to the amount of the debt cancelled or forgiven.7 There are several exceptions to recognition of COD income that may apply in workouts involving real property indebtedness.

B. Material Modification of Debt.

COD income may be recognized even if the debt is not actually cancelled. A change in the terms of debt securing real estate can trigger COD income to the owner. This result may occur if the debt is either replaced by new debt or the terms of the debt are materially modified.

1. Replacement of Existing Debt.

If a debtor replaces an existing debt with new debt, the debtor will be treated as having satisfied the old indebtedness with an amount of money equal to the issue price of the new debt.8 Therefore, if the issue price of the new debt is less than the adjusted issue price of the old debt, the debtor will realize COD income. The issue price of the new debt is determined under the original issue discount ("OID") rules. The new debt instrument may also contain OID that would provide the debtor with interest deductions, however, the deductions will be spread over the term of the debt instrument. Because of the time value of money, the deductions will not fully offset any recognized COD income.

2. Modification of Existing Debt.

If the terms of an existing debt are materially modified in kind or extent, the debtor will be treated as having exchanged the original debt for new debt.9 If the debt modification is treated as a deemed exchange, COD income may be recognized pursuant to Section 108(e)(10). If the modification is not deemed to be material, there will be no tax consequences to the borrower.

(a) When Modification of a Debt is Material.

Proposed Treasury Regulations § 1.1001-3, were issued in December 1992, in response to the Supreme Court decision in Cottage Savings Association v. Commissioner.10 If adopted, the regulations would expand the scope of circumstances under which COD income may be triggered in a negotiated workout. Under Proposed Treasury Regulations § 1.1001-3, any "significant modification" in the terms of a debt instrument will be considered an exchange. A modification of a debt instrument is defined as any alteration in any legal right or obligation of the issuer or holder unless the modification occurs by operation of the original terms of the instrument. The Proposed Treasury Regulations contain an expansive list of modifications considered "significant", including:

(i) A change in the yield to maturity of more than 25 basis points;

(ii) An extension of the final maturity of more than the lesser of five years or 50% of the original term;

(iii) The addition or deletion of put or call rights if such rights have significant value at the time of the addition or deletion;

(iv) Changes in the obligor of recourse (but not nonrecourse) debt;

(v) The addition or material alteration of a guarantee or other form of credit enhancement in a nonrecourse debt;

(vi) A change in collateral securing nonrecourse debt if a substantial portion of the collateral is released or replaced with other property;

(vii) A change of a fixed rate instrument to a variable rate instrument or a contingent payment instrument;

(viii) A change of a variable rate instrument to a fixed rate instrument or a contingent payment instrument;

(ix) A change of a contingent payment instrument to a fixed rate instrument or a variable rate instrument;

(x) A change of the currency in which payments on the debt instrument are made; and

(xi) A change from recourse to nonrecourse or vice versa.

There is language in the Proposed Treasury Regulations that may require retesting for debt-equity purposes whenever debt is substantially modified.11 With so much real estate under water this could make lenders partners or owners of real estate when even under-water debt is modified, with disastrous tax consequences to the owners.

Proposed Treasury Regulations § 1.1001-3 was issued as a discussion draft. The American Bar Association Tax Section formed a task force that has recommended that the Proposed Treasury Regulations be withdrawn and that a legislative solution be adopted. In August 1993, the American Bar Association Tax Section adopted Legislative Recommendation No. 1993-2 that would reinstate the rule of prior Section 1275(a)(4) and broaden its application to partnership and individual debtors so long as the principal amount of the indebtedness is not changed (taking into account the applicable Federal rate). Under the Legislative Recommendation a modification of the debt that did not reduce the principal amount of the debt would not give rise to income to either the debtor or creditor.

C. Acquisition of Existing Debt by a Related Party.

A debtor may realize COD income when a person related to the debtor acquires the debt at a discount from a person unrelated to the debtor.12

IV. Exceptions.

A. Bankruptcy.

Cancellation of indebtedness of bankrupt taxpayers is excluded from income.13 Bankrupt taxpayers are those under the jurisdiction of the bankruptcy court where the discharge of indebtedness is either granted by the court or pursuant to a plan approved by the court.14

B. Insolvency.

Gross income does not include income from discharge of indebtedness of an insolvent taxpayer.15 The amount excludable from gross income by an insolvent taxpayer is limited to the amount by which the taxpayer is insolvent.16 A taxpayer is considered insolvent if the liabilities of the taxpayer immediately preceding the discharge of the debt exceed the fair market value of the taxpayer's assets.17 In Revenue Ruling 92-53,18 the Service stated that, in determining solvency it will ignore nonrecourse debt in excess of the value of the property securing that debt (except where that excess nonrecourse debt itself is being forgiven). In determining solvency, exempt assets under state law are not included in the taxpayer's assets.19

1. Attribute Reduction.

A taxpayer who excludes COD income from gross income due to the bankruptcy or insolvency exception is required to reduce other tax attributes by the amount of the excluded income. This reduction is done in the following order of priority:

(a) net operating losses and net operating loss carryovers;

(b) general business credits under Section 38;

(c) alternative minimum tax credits;

(d) net capital losses and capital loss carryovers;

(e) the basis of depreciable property (to the extent the basis exceeds remaining liabilities);

(f) passive activity losses and credit carryovers; and

(g) foreign tax credits and carryovers.20

The reduction in attributes occurs after the determination of tax for the year of the discharge.21 Attributes are reduced dollar-for-dollar, except for tax credits, which are reduced 33-1/3 cents for each dollar.22 A taxpayer may instead elect to first reduce the basis of depreciable property. The reduction in basis is limited to the taxpayer's adjusted basis of depreciable property held at the beginning of the taxable year following the taxable year in which the debt is discharged.23 (The reduction in basis is not limited to the excess of the basis in depreciable property over remaining liabilities.)24 Reductions in the basis of depreciable property are made in the following order of priority: (i) depreciable property for which the debt was incurred, (ii) other depreciable property securing the debt, and (iii) all remaining depreciable property.25

2. Cancellation of Partnership Indebtedness.

If real estate is owned by a partnership and the partnership realizes COD income, whether such income must be recognized is determined separately for each partner.26 A bankrupt or insolvent partner would not recognize taxable income currently but would reduce other tax attributes and would have the opportunity to elect to reduce the basis of depreciable property. A partner's interest in depreciable property includes the basis of partnership interests to the extent of the partner's proportionate interest in the partnership depreciable property if there is a corresponding reduction in the partnership's basis in the property with respect to such partner.27 A solvent partner would recognize taxable income unless the exclusion enacted in 1993 for qualified real property business indebtedness applies (discussed below).

3. Cancellation of S Corporation Indebtedness.

If real estate is owned by an S Corporation, the insolvency and bankruptcy exceptions are applied at the corporate level, not the shareholder level.28 Further, corporate attributes, not the attributes of the shareholders, will be reduced under Section 108(b). Because of the pass-through nature of an S corporation, the only attribute the corporation should have to reduce is basis in its property. Additionally, any loss that is suspended under Section 1366(d)(1) is treated as an NOL.29

C. Purchase Price Adjustment.

1. General Rule.

A reduction in seller-provided debt does not result in COD income for a solvent debtor. The reduction in debt is treated as a reduction in purchase price and results in a reduction in the debtor's adjusted basis in the property acquired with the debt.30 The legislative history to Section 108(e)(5) provides that neither the property nor the debt obligation may be transferred.31 Thus, the purchase price adjustment exception only applies between the original purchaser and seller.32 The reduction is not limited to depreciable property. The purchase price adjustment rules are not elective.

2. Partnerships.

Where the debtor is a partnership, the purchase price adjustment is made at the partnership level.33 Where the partnership is bankrupt or insolvent, but the partners are solvent, the Service stated in Revenue Procedure 92-9234 that it would not challenge the partnership's use of the purchase price adjustment provided that all of the partners use consistent income tax reporting.

3. Common Law Purchase Price Adjustment.

The statutory purchase price adjustment rules of Section 108(e)(5) are very narrow because they only apply to seller financing. The legislative history to the Bankruptcy Tax Act of 1980 indicates that Section 108(e)(5) was not to be exclusive and that the old judicial purchase price reduction exception rules continue to apply.35 Thus, the judicial exception may apply to non-seller financing. The cases under the judicial exception require the purchase price to be reduced because of a decline in value of the property.36 Thus, the property should be appraised to establish its value. In Revenue Ruling 92-99,37 the Service stated that it would not follow the judicial purchase price exception rules in cases where non-seller debt was involved.

D. Qualified Real Property Business Indebtedness.

1. General Rule.

The Revenue Reconciliation Act of 1993 added an exception for COD income related to "qualified real property business indebtedness" of taxpayers other than C corporations.38 The new exception applies to discharges of real property business indebtedness occurring after December 31, 1992.39 Taxpayers, other than C corporations, may elect to exclude from gross income a portion of the income derived from the discharge of qualified real property business debt. The election must be made by filing Form 982 with the taxpayer's return for the taxable year in which the discharge occurs.40 The amount of excluded income is treated as a reduction in the basis of the taxpayer's depreciable real property.41 The amount excluded cannot exceed the taxpayer's basis in the depreciable real property and is also limited to the excess of the amount of the principal of the debt over the fair market value of the property securing the debt (reduced by the principal amount of any other qualified real property indebtedness secured by the property).42 The Service is considering whether accrued interest should be included in the principal of the debt.43

2. Definition of Qualified Real Property Business Indebtedness.

"Qualified real property business indebtedness" is debt incurred or assumed in connection with real property used in a trade or business and secured by that property. However, it does not include debt incurred or assumed on or after January 1, 1993, unless that debt is incurred to acquire, construct or substantially improve the real property secured by the debt or is incurred to refinance qualified real property business debt incurred or assumed before that date (but only to the extent the amount of the debt does not exceed the amount being refinanced).44

3. Partnership and S Corporations.

With respect to partnerships and S corporations, the determination of whether the debt is qualified real property indebtedness is made at the entity level. For partnerships the election to exclude income and reduce the basis of property is made by the partner. For S corporations the election is made by the S corporation, not by its shareholders. Partners which are C corporations are not eligible to make the election. If a partner makes the election, basis is reduced in the partner's interest in the partnership to the extent of the partner's proportionate interest in the depreciable real property held by the partnership. The partnership's basis in depreciated real property with respect to such partner is correspondingly treated.45 It appears that a partner may reduce the basis of depreciable real estate held outside the partnership if the partner's share of partnership depreciable basis is insufficient. However, this may give rise to partnership tax problems discussed in Part V below.

4. Basis Reduction.

The required basis reduction generally applies to depreciable real property held by the taxpayer at the beginning of the taxable year following the taxable year in which the debt is discharged.46 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 taxable year, then the reduction in basis of such property is made immediately before the disposition.47 Taxpayers may not make the election available under present law to treat as depreciable real property real estate held primarily for sale to customers.48 When depreciable real property, the basis of which has been reduced, is disposed of, then for purposes of determining the amount of ordinary income depreciation recapture under Section 1250 -- (i) the basis reduction is treated as an allowance for depreciation, and (ii) the determination of depreciation under the straight line method is made as if there had been no reduction. Accordingly, the amount of ordinary income depreciation recapture is reduced over time as the taxpayer forgoes depreciation deductions.49

V. Reporting Requirements.

The Revenue Reconciliation Act of 1993 added a provision that requires an "applicable financial institution" to file an information return (Form 1099-C) when it has discharged debt of $600 or more. These rules generally apply to discharges occurring after December 31, 1993, except in the case of certain governmental entities where they apply to discharges after August 10, 1993, the date of the Act.50 An "applicable financial institution" is a bank, savings & loan, credit union, certain governmental entities, or subsidiaries of the above-described entities. The Service issued Temporary Regulations § 1.6050P-1 governing the procedures to be followed under the reporting requirements.

VI. Partnership Rules Causing Income Recognition.

Where a partnership owns real estate, a debt modification that does not cause COD income at the partnership level nevertheless may give rise to income at the partner level under the following provisions, which are described very briefly.

A. Distribution in Excess of Basis - Section 731(a)(1).

A partner's basis in his or her partnership interest includes the partner's share of partnership liabilities.51 The basis is decreased by any decrease in the partner's share of partnership liabilities, which is treated as a distribution of money.52 If a partner receives a distribution of money from a partnership (including a deemed distribution under Section 752(b) caused by a reduced share of liabilities) and the amount distributed exceeds the partner's basis in the partnership interest, the partner will recognize gain to the extent of the excess. This can happen when debt is paid down, forgiven, or debt is reallocated to another partner pursuant to Section 752 and the Regulations thereunder. Debt can be reallocated pursuant to Section 752 when it is converted from nonrecourse to recourse, or if it is converted from nonrecourse to partner nonrecourse by virtue of a partner guaranteeing the debt or a lender becoming a partner.53 Under Section 731(a)(1) the test for determination of gain is to be made immediately before the distribution. However, in Revenue Ruling 92-97,54 the Service stated that where debt was forgiven in mid-year, the test for debt relief will be made at year end and the earlier distribution will be treated like a partnership draw. Otherwise income could be triggered twice since the cancellation of indebtedness is not allocated to the partners until year end to increase their tax bases.

B. Partnership Allocations Minimum Gain Chargeables Section 704(b).

When partners take losses based on nonrecourse liabilities they increase their share of partnership minimum gain.55 If there is a net decrease in partnership minimum gain for any year the Treasury Regulations require that the partners be allocated items of gross income as a minimum gain chargeback to reflect such decrease.56 There are limited exceptions to this minimum gain chargeback, such as (i) where a partner has become personally liable on what was nonrecourse debt, or (2) has contributed money to the partnership to the extent of the reduction or (3) the chargeback would cause a distortion to the economic deal of the parties through its impact on capital accounts.57 Workouts and contributions of new capital can often cause minimum gain chargebacks. Sometimes the chargeback problem can be avoided by a book up of the partnership assets.58 A partner's election under new Section 108(c) to reduce basis beyond his or her share of the partnership's basis of depreciable real property could trigger gain under a minimum gain chargeback. It is hoped that the Service will provide relief in this area to carry out the legislative intent.

C. At Risk Rules - Section 465.

A partner can deduct losses from real estate investment only to the extent the partner is at risk.59 The at-risk rules do not apply to real estate acquired before December 31, 1986. Partners who acquire an interest in a pre-existing partnership after December 31, 1986 are subject to the at-risk rules. A partner's at-risk amount is increased by the partner's share of qualified nonrecourse financing secured by the real property.60 If a partner's at-risk amount becomes negative, the partner must include the negative amount in income.61 This would occur as part of a workout if qualified nonrecourse financing is converted into or refinanced by debt that does not so qualify. A partner's election under new Section 108(c) to reduce basis beyond his or her share of the partnership's basis of depreciable real property could produce a negative at-risk amount triggering income. It is hoped that the Service will provide relief in this area to carry out the legislative intent.

VII. Individual Issues.

If the debtor is unsuccessful in getting the bank to renegotiate the debt on the property, the debtor may want to consider bankruptcy.

If an individual files a Chapter 7 or 11 bankruptcy petition, a separate tax estate is created.62 Both the individual and the estate file separate tax returns based upon separate tax years. The tax attributes of the debtor and the debtor's property are transferred to the estate.63 The debtor may be able to transfer the tax liability on the potential gain (if the Lender forecloses) to the estate. If the asset is transferred to the estate and then transferred to the Lender, the tax becomes an administrative expense payable out of the estate.64 Some commentators have suggested filing a Chapter 11 petition, transferring the property, and then converting to a Chapter 7.

1 See Helvering v. Hammel, 311 U.S. 504 (1941); Tres. Reg. § 1.1001-2(a)(1).

2 See Commissioner v. Tufts, 461 U.S. 300 (1983); Crane v. Commissioner, 331 U.S. 1 (1947).

3 See Bressi v. Commissioner, 62 T.C.M. 1668 (1991); Treas. Reg. §§ 1.1001-2(a)(2), 1.1001-2(c), Example (8).

4 Some cases have not followed the bifurcation approach of the regulations. See Chilingirian v. Commissioner, 52 T.C.M. 606 (1986), aff'd, 90-2 U.S.T.C. ¶ 50569 (6th Cir. 1990); Aizawa v. Commissioner, 99 T.C. 197 (1992). The Internal Revenue Service (the "Service") has taken the position that a disposition of property secured by a recourse liability must be analyzed in accordance with the bifurcation method of the regulations. Rev. Rul. 90-16, 1990-1 C.B.12; G.C.M. 39814 (March 30, 1990); T.A.M. 8504010 (October 26, 1985).

5 See Tech. Adv. Mem. 8348001 (August 18, 1983).

6 See, Market Segment Specialization Program, Resolution Trust Corporation: Cancellation of Indebtedness; DTR Special Supp. (March 3, 1995).

7 Section 61(a)(12).

8 Section 108(e)(10).

9 Treas. Reg. §1.1001-1(a).

10 499 U.S. 554, 111 S.Ct. 1503, (1991).

11 Prop. Treas. Reg. §§1.1001-3(c)(3) and (e)(4)(i).

12 Section 108(e)(4).

13 Section 108(a)(1)(A).

14 Section 108(d)(2).

15 Section 108(a)(1)(B).

16 Section 108(a)(3).

17 Section 108(d)(3).

18 1992-2 C.B. 48.

19 See Hunt v. Comm'r, 57 TCM 919 (1989); PLR 9125010 (March 19, 1991); PLR 9130005 (March 29, 1991); PLR 8920019 (February 14, 1989).

20 Section 108(b)(2).

21 Section 108(b)(4)(A).

22 Section 108(b)(3).

23 Section 108(b)(5).

24 Section 1017(b)(2).

25 Treas. Reg. §1.1017-1(a).

26 Section 108(d)(6).

27 Section 1017(b)(3)(C).

28 Section 108(d)(7)(A).

29 Section 108(d)(7)(B).

30 Section 108(e)(5).

31 See S. Rep. No. 1035, 96th Cong., 2d Sess. 16-17 (1980).

32 The Service has not strictly applied the original purchaser/seller rule. In PLR 9037033 (June 18, 1990), the original purchaser of stock transferred both the stock and the debt obligation to a holding company in a Section 351 transaction. The holding company later renegotiated the debt with the original seller. The Service stated that Section 108(e)(5) applied to the transaction.

33 See PLR 8429001 (March 12, 1984).

34 1992-2 C.B. 505.

35 Senate Report 96-1035, 2d Session. 20, note 24, (1980) (1980-2 C.B. 620, 630).

36 See Sutphin v. United States, 88-1 USTC ¶ 9269 (Cl. Ct. 1988); Comm'r v. Sherman, 135 F.2d 68 (6th Cir. 1943); Hirsch v. Comm'r, 115 F.2d 656 (7th Cir. 1940).

37 1992-2 C.B. 35.

38 Section 108(a)(1)(D) and 108(c).

39 As of April 1, 1995, California has not yet enacted contingency legislation to new Section 108(c).

40 Temp. Treas. Reg. § 1.108(c)-1T(b). Announcement 94-11, I.R.B. 1994-4, 14.

41 Section 108(c)(1)(A).

42 Section 108(c)(2).

43 See BNA Daily Tax Report 9-10-93, p G-11.

44 Section 108(c)(3).

45 House Report 103-213, 1st Session, pp. 51-52 (1993).

46 Section 1017(a).

47 Section 1017(b)(3)(F)(iii).

48 Section 1017(b)(3)(F)(ii).

49 House Report 103-213, 1st Session, p. 52 (1993).

50 Section 6050(P) -- (1993 Act § 13252(a)).

51 Section 752(a).

52 Section 752(b).

53 Treas. Regs. §§1.752-2(c)(1) and (2).

54 1992-2 Cum. Bull. 124.

55 Treas. Regs. §1-704-2(c)(1) and (g).

56 Treas. Reg. §1.704-2(f).

57 Treas. Reg. §1.704-2(f)2-4.

58 See Treas. Regs. §§1.704(2)(d)(4), 1.704-2(q)(2) and 1.704-2(m) Ex. 3(ii).

59 Section 465(a)(1).

60 Section 465(b)(6).

61 Section 465(e).

62 Section 1398(a). A separate tax estate is not created when a partnership or corporation files a bankruptcy petition. Section 13299.

63 Section 1398(g).

64 However, the trustee may attempt to abandon the property. The consequences of abandonment are unsettled.

Questions, comments or suggestions? kbercik@taxcounsellor.com

Last updated February 2, 1998

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