Dispositions of property in satisfaction of debt.

• Author: Mihelich, Michael J.

A taxpayer considering transferring assets to settle a debt should carefully analyze the tax consequences before entering into such a transfer. A combination of gain from the deemed sale of the property and cancellation of debt (COD) income may result. Under certain circumstances, the taxpayer may qualify for tax favored treatment, such as deferral or elimination of the COD income.

Background

According to Rev. Rul. 90-16, a taxpayer is treated as having sold or exchanged property when he or she transfers property to a creditor in discharge of debt, regardless of whether the transfer is a voluntary conveyance by deed or an involuntary foreclosure. The debt's character (i.e., recourse or nonrecourse) determines the transfer's tax consequences.

Recourse Debt

Regs. Sec. 1.1001-2 explains that if property is transferred to satisfy recourse debt, the transfer is divided into two transactions.The first transaction is tim sale or exchange of the property. The amount realized is the loan amount, to the extent of the transferred property's fair market value (FMV). The amount realized, less the property's adjusted tax basis, results in the gain or loss.

The second transaction computes the COD income, which is the debt discharged in excess of the FMV of the property transferred.

Example 1: J owns property with a $40,000 basis that is subject to a $50,000 recourse debt. The property's FMV is $20,000. J transfers the property to the creditor in satisfaction of the debt. His amount realized includes the $50,000 liability relieved, under Regs. Sec. 1.10012(a)(1), but is limited to the property's $20,000 FMV. His basis is $40,000, so he has a $20,000 loss on the exchange ($20,000 realized - $40,000 basis). J also has $30,000 of COD income ($50,000 debt--$20,000 FMV) on the transfer.

Nonrecourse Debt

When property is transferred to satisfy a nonrecourse debt, the transaction is treated as a sale or exchange of the property transferred, under Regs. Sec. 1.1001-2(c), Example (7). The realized gain or loss is the difference between the amount realized and the taxpayer's adjusted basis in the property; no COD income is realized.

Example 2: The facts are the same as in Example 1, except that the debt is nonrecourse. J's amount realized is $50,000, but his realized gain is $10,000 ($50,000 amount realized--$40,000 adjusted basis). There is no COD income.

Partially Recourse Debt

As explained in Letter Ruling 8348001:

When a debt is partially recourse and partially...