Applying the sec. 108(c) basis adjustment election to foreclosures.

• Author: Williamson, Donald T.

Although real estate values are rebounding in some areas, they will likely continue to be depressed for the foreseeable future. When an owner surrenders mortgaged real estate, the fair market value (FMV) of which is less than the face amount of the debt, the transfer of title to the mortgagee in satisfaction of the obligation may result in taxable gain and/or loss from both the disposition of the property and the discharge of the underlying debt. While the debtor may feel relief from cancellation of his repayment obligation, under Sec. 61(a)(12), the cancellation of debt (COD) is the receipt of income.

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...