Consider disposing of depreciable real property or making a sec. 108(c) (3) (C) election in the same year that debt is discharged.

• Author: Dudzinsky, Robert J.

Generally, under Sec. 61 (a) (12), gross income means all income from whatever source derived, including income from discharge of indebtedness. Consequently, unless a statutory exclusion applies, discharge of indebtedness income is recognized on the cancellation, reduction or forgiveness of debt and/or the transfer of encumbered property (see, e.g., Kirby Lumber Co., 284 US 1 (1931)). Typically, the amount of discharge of indebtedness income equals the amount of debt discharged less the amount paid by the debtor to the creditor.

However, when encumbered property is transferred in a foreclosure or in lieu of foreclosure, the recognition of discharge of indebtedness income depends on whether the debt is recourse or nonrecourse. Under Regs. Sec. 1.1001-2(a), relief from indebtedness resulting from the transfer of property encumbered by nonrecourse debt is deemed derived from the disposition of such property. Therefore, the gain is treated as part of the amount realized from the sale or exchange of the property and no discharge of indebtedness income results. Alternatively, under Regs. Sec. 1.1001-2(c), Example 8, and Danenberg, 73 TC 370 (1979), relief from indebtedness resulting from the transfer of property encumbered by recourse debt may be both discharge of indebtedness income and gain derived from the disposition of the property. The regulations appear to bifurcate the transaction, and provide that gain from the sale or exchange of property arises to the extent that the property's fair market value (FMV) exceeds its basis and debt discharge income arises to the extent of the excess of the debt over the FMV.

Under Sec. 108(a), amounts includible in gross income resulting from discharge of indebtedness income may be excluded when the discharge occurs in a bankruptcy proceeding, while the debtor is insolvent, if the debt is qualified farm indebtedness, or if the debt is qualified real property business indebtedness and an election under Sec. 108(c) (3) (C) is made by a non-C corporation tax-payer. Hence, if debt is relived through the transfer of nonrecourse encumbered property...