Category: Miscellaneous
Subject: COD Income
Title: Housing Cooperative
IRC Sections: 108(e), 1017, 111(c), 61(a)(12)
Filename: 1198.html
Date Produced: 02/95 Copyright 1998, The Tax Resource Group. All rights reserved. Telephone
800-578-3498. Internet: www.taxresourcegroup.com Facts
Taxpayer (TP) is an accrual basis housing cooperative. As of 12/31/93, TP
had purchase money indebtedness outstanding (a second mortgage) of $510,375
consisting of $300,000 principal and $210,375 accrued interest. No interest
accruals were made in 1994. During calendar 1994, TP satisfied the entire
obligation (both principal and interest) for $186,871. Issues
1. Is it possible to exclude from income the principal portion of the debt
discharge under the purchase price reduction rules and take a corresponding
reduction in the basis of the property? 2. Can the interest portion of the discharge be excluded by reducing
the net operating loss? 3. Is the shareholder deduction for payments made with respect to the
first mortgage affected by the circumstances surrounding discharge of the
second mortgage? Answers
1. Assuming TP is solvent, the principal portion of the debt relief can
be excluded from income with a concomitant reduction of the basis of TP's
property. 2. The interest portion of the debt relief cannot be excluded from income. 3. Shareholder deductions with respect to the first mortgage are unaffected
by the discharge of the second mortgage. Discussion: Issue 1
Internal Revenue Code Section 108(e)(5) allows exclusion of otherwise includable
debt cancellation (COD) income. The debtor must be solvent and the cancellation
cannot result from bankruptcy of the debtor. As I understand it, TP purchased
the property which gave rise to the second mortgage directly from the current
holder, Mr. Mr. H. If that is not the case, Section 108(e)(5) may not be
available. Any COD income so excluded reduces the basis of TP's property
under Section 1017. Discussion: Issue 2
COD income related to accrued interest for which TP has taken a deduction
previously clearly cannot be excluded from income. See Sections 108(e)(2)
and 111(c). Relief of the accrued interest portion of this debt is subject
to the general rules of inclusion of COD income under Section 61(a)(12).
Since TP is solvent and the debt is discharged outside bankruptcy, there
is no provision available under which the COD income related to the accrued
interest portion of this debt can be excluded. Discussion: Issue 3
I can see no reason why the amounts paid by shareholders of the cooperative
with respect to the first mortgage should be affected by any of the circumstances
surrounding the second mortgage. The shareholders are clearly entitled under
Section 216 to their shares of interest related to the first mortgage, and
there is no indication that relief of the second mortgage should change
that. Important Collateral Issues
1. Since the characterization of the amount of debt discharged as between
accrued interest and principal significantly impacts the taxation of the
transaction, care must be taken to properly characterize these amounts.
I disagree with the premise that the total discharge should be allocated
on a pro-rata basis. I do not believe that the tax law provides an answer
to the question of allocation, and I would be very cautious about making
any assumptions in this area. I believe that either the note itself or local
law will control. I am not an attorney. I urge you to consult a competent
attorney in your state regarding this issue. 2. A shareholder's portion of the co-op mortgage is usually counted as
part of the basis of the shareholder's stock. See Revenue Ruling 60-76,
1960-1 CB 296. As I understand it, the governing documents of a co-op or
the proprietary lease generally require payments commensurate with the debt
service requirements of the co-op mortgage. It is also my understanding
that in some cases the shareholders actually assume the co-op mortgage as
well. The collateral issue not raised in your queries to me is whether there
is potential COD income at the shareholder as well as at the corporate level.
I believe that there is significant exposure on this point and I urge that
if you have not already done so, you investigate the facts and thoroughly
pursue this issue. In essence, it seems likely to me that not only was the
corporation relieved of the debt but also the shareholders were indirectly
relieved either of debt or of the obligation to support debt service. A
taxpayer typically enjoys a tax-free increase in the basis of encumbered
property equal to the amount of debt on the property. When debt is discharged,
the obligation supporting that basis is removed and income must be recognized.
This is one of the theoretical underpinnings of why debt discharge gives
rise to income. Because of the linkage between the basis of a cooperative
stockholder's shares and debt of the co-op, I believe there may be COD potential
when co-op level debt is discharged. | 
