Nonrecourse debt in determining insolvency under Sec. 108.

• Author: Haskell, Arnold

In these times of declining real estate values and severe economic recession, situations arise in which debt is restructured and ultimately reduced in amount. This reduction in debt is generally included as gross income from the "discharge of indebtedness" under Sec. 61(a)(12).

Sec. 108 provides an income exclusion for income from the discharge of indebtedness, if the debt discharge occurs when the taxpayer is insolvent. The Sec. 108 exclusion is then limited to the amount by which the taxpayer is insolvent.

Generally, the Sec. 108 exclusion is not a total windfall for the taxpayer; there is a required reduction at the beginning of the year following the year of discharge of certain specified tax attributes (net operating losses, asset bases, credit carryovers, etc.). Therefore, the extent of the taxpayer's tax attributes after year-end will determine whether the exclusion is permanent or merely a deferral. Since insolvency is the key to exclusion, it is important to know how to define this term.

The determination of insolvency is made immediately prior to discharge and is defined under Sec. 108[d][3] as the excess of the taxpayer's liabilities over the fair market value [FMV] of its assets. Since the Code does not provide a definition of "liabilities," this term has become a matter of judicial and legislative interpretation. The rationale has always been to provide the taxpayer with a "fresh start" not hampered by the imposition of a tax that the taxpayer is unable to pay.

Until now, there has been some uncertainty as to how nonrecourse debt is treated for purposes of determining insolvency under Sec. 108[d][3]. The IRS recently clarified its position on the treatment...