Basis reduction due to discharge of indebtedness: proposed regs.

• Author: Liquerman, Robert

On Jan. 7, 1997, the IRS issued proposed regulations under Sec. 1017, specifying the manner and timing of reductions to asset basis accompanying the exclusion of discharge of indebtedness (COD) income from gross income; specific rules for applying Sec. 1017 to partnerships are also provided. The regulations are proposed to be effective on or after the date final regulations are published.

Background

Sec. 108(a) generally excludes COD income from gross income if:

* The debtor taxpayer is in a Title 11 case (bankruptcy);

* The debtor taxpayer is insolvent (to the extent of insolvency);

* The discharged debt is qualified farm indebtedness (QFI); or

* In the case of a taxpayer other than a C corporation, the discharged debt is qualified real property business indebtedness (QRPBI).

However, the mere exclusion of COD income is not the final consequence. If COD income is excluded from gross income due to bankruptcy, insolvency or QFI exceptions, Sec. 108(b)(2) requires a reduction of the debtor's tax attributes in the following order: (1) net operating losses (NOLs); (2) general business credits; (3) minimum tax credits; (4) capital loss carryovers; (5) basis in assets; (6) passive activity losses and credit carryovers; and (7) foreign tax credit carryovers. If the excluded COD income exceeds these attributes, the excess can be excluded from gross income without further consequences. If COD income is excluded from gross income due to the QRPBI exception, Sec. 108(c) requires only a reduction in the basis of the taxpayer's depreciable real property. Sec. 108(c) also provides for limitations on the QRPBI exception, which may result in all or a portion of the COD income being included in the taxpayer's gross income.

If basis is reduced pursuant to Sec. 108(b)(2)(E), Sec. 1017 governs the timing of the reductions. That section provides that basis reductions generally apply to properties held by the taxpayer at the beginning of the tax year following the tax year in which the discharge occurs. The proposed regulations focus on category 5 above (basis in assets), specify the properties whose bases are to be reduced and provide rules governing the amount of these basis reductions. Although the proposed regulations retain the general basis reduction rules set forth in regulations issued in 1956, they modify the prior rules in the interest of simplification and provide additional rules that reflect 40 years of statutory developments.

General Rules

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