Tax consequences of partnership workout arrangements.

• Author: Glass, Elliott

In many areas of the country, the real estate market has been particularly hard hit by our weak economy. While one result of this situation has been a substantial number of foreclosures of real property, it is increasingly more common to find that, rather than foreclose on properties, lenders are willing to work out debt restructuring to enable the owners to continue to maintain the property.

During the height of the real estate boom market in the late 1970s and early 1980s, the vehicles of choice for owning real estate were partnerships, in particular, syndicated limited partnerships. Partnerships worked exceptionally well, as they enabled the losses generated by depreciation (and in some cases accrued interest on mortgages) to be used by the limited partners. Further, some partnerships permitted the distribution of cash from the property (generated either from ongoing operations or from refinancing mortgages at a higher amount) to the partners on a tax deferred basis.

Now that many of these partnerships are experiencing economic difficulties, several tax implications to workout agreements must be considered, in addition, there are a few tax issues and considerations unique to the partnership structure.

A typical workout involves some combination of the following items.

* Reduction of currently required mortgage payments.

* Deferral of previously scheduled principal payments.

* Reduction of interest rate on the mortgage note going forward.

* Outright reduction of the face of the indebtedness.

As with any debt restructuring, the first provision to be considered is Sec. 108. In general, gross income includes income from the discharge of indebtedness. However, there are numerous exceptions in Sec. 108 that operate to reduce, eliminate or defer the taxability of such forgiveness income. Since the typical real estate venture was a single asset venture [i.e., the partnership was formed to acquire one piece of real property and has substantially no other assets], and the rationale for the workout is that the value of the property is now lower than the outstanding mortgage balance, it is reasonable to conclude that the general "insolvency section" of See. 108(a)(l)(B)would apply. However, Sec. 108(d)(6)specifies that certain portions of Sec. 108 (including the insolvency exception) must be applied at the partner level. In many cases involving syndicated partnerships, this effectively makes the insolvency exception unavailable, as it would require...