Reduction of nonrecourse debt.

• Author: Perkins, Michael F.

Example: D borrowed $1,000,000 from C in 1991. D had no personal liability for this debt, which was secured by an office building (valued at $1,000,000) that D acquired from S with the proceeds of the nonrecourse financing. In 1992, when the building's value was $800,000 and the amount of the debt was still $1,000,000 C reduced the debt to $800,000. When the debt was reduced, D was not bankrupt or insolvent.

What is the amount, if any, of D's debt discharge income?

Under Fulton Gold Corp., 31 BTA 519 (1934), D has no debt discharge income. However, D's basis in his office building must be reduced by $200,000.

On the other hand, under Rev. Rul. 91-31, D has $200,000 debt discharge income. The basis in D's office building is not reduced by this $200,000 debt reduction. (See the Tax Clinic item, "Debt Discharge Guidance Issued," TTA, Jan. 1992, at 25.)

Rev. Rul. 91-31 held that Sec. 61(a)(12) provides that gross income includes income from the discharge of indebtedness. Regs. Sec. 1.61-12(a) provides that the discharge of indebtedness, in whole or in part, may result in the realization of income.

In Rev. Rul. 82-202, a taxpayer prepaid the mortgage held by a third-party lender on the taxpayer's residence for less than the mortgage's principal balance. At the time of the prepayment, the residence's fair market value (FMV) was greater than the mortgage's principal balance. That ruling held that the taxpayer realized discharge of indebtedness income under Sec. 61(a)(12), whether the mortgage was recourse or nonrecourse and whether it was partially or fully prepaid. Rev. Rul. 82-202 relied on Kirby Lumber Co., 284 US 1 (1931), in which the Supreme Court held that a taxpayer realized ordinary income on the purchase of its own bonds in an arm's-length transaction at less than their face amount.

In Tufts, 461 US 300 (1983), the Supreme Court held that when a taxpayer sold property encumbered by a nonrecourse obligation that exceeded the property's FMV, the amount realized included the amount of the obligation discharged. Because a nonrecourse note was treated as a true debt on inception (so that the loan proceeds were not taken into income at that time), a taxpayer was bound to treat the nonrecourse note as a true debt when the taxpayer was discharged from the liability on disposition of the collateral, despite the collateral's lesser FMV (see Regs. Sec. 1.1001-2(c), Example 7).

In Gershkowitz, 88 TC 984 (1987), the Tax Court concluded that the...