Category: Bankruptcy, Insolvency & Debt Discharge; Partnerships & LLCs
Subject: Section 108 Qualified Real Property Indebtedness
Title: Interaction with Insolvency Exception/Mechanics of Election
IRC Sections: 108
Filename: 1301.html
Date Produced: 02/94

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Taxpayer (TP) is partnership which owns and operates an apartment complex. TP's lender has agreed to reduce the mortgage on the property.

Issue
If the transaction qualifies in all other respects for qualified real property indebtedness treatment under Internal Revenue Code §§108(a)(1)(D) and 108(c), can TP (or TP's partners) claim the exclusion under §108(a)(1)(D) if all the partners are solvent?

Answer
The partners of TP need not be insolvent in order to exclude cancellation of indebtedness (COD) income under §108(a)(1)(D). The statute is clear on its face that the various means of excluding COD income, i.e., insolvency, bankruptcy, real property indebtedness, and farm indebtedness are all independent options.

108(a)(1) IN GENERAL.--Gross income does not include any amount which
(but for this subsection) would be includible in gross income by reason of
the discharge (in whole or in part) of indebtedness of the taxpayer if--

108(a)(1)(A) the discharge occurs in a title 11 case,

108(a)(1)(B) the discharge occurs when the taxpayer is insolvent,

108(a)(1)(C) the indebtedness discharged is qualified farm indebtedness, or

108(a)(1)(D) in the case of a taxpayer other than a C corporation, the
indebtedness discharged is qualified real property business indebtedness.

As you can see, each of the various options is connected by the word "or" which of course indicates that each option functions independently.

Nothing in the Committee Reports surrounding the enactment of this provision casts any doubt on the conclusion set forth above.

The Mechanics
You also requested assistance regarding the mechanics of all this. First of all, the provision is elective. §108(c)(3)(C). To the extent the taxpayer elects to exclude COD income under this provision, the basis reduction rules of §1017 apply. In general, these rules require that the basis of depreciable property be reduced at the beginning of the tax year following the exclusion event.Partnerships present some rather peculiar problems. §108(d)(6) provides that the exclusion of COD income for qualified real property indebtedness is applied at the partner level. The Committee Reports provide guidance as follows:

...In the case of discharge of indebtedness of a partnership, the determination of whether debt is qualified real property indebtedness (and the application of the fair market value limitation) is made at the partnership level. For example, if partnership debt is discharged, the determination of whether the debt was incurred or assumed in connection with real property used in a trade or business is made by reference to the trade or business of the partnership and real property owned by the partnership.

The election to apply the provision is made at the partner level, however, on a partner by partner basis. An interest of a partner in a partnership that owns depreciable real property is treated as depreciable real property to the extent of the partner's proportionate interest in the depreciable real property held by the partnership. The partnership's basis in depreciable real property with respect to such partner is correspondingly reduced.

Also:

...The deemed distribution (under Code section 752) arising from the reduction in a partner's share of partnership liabilities attributable to the discharge of partnership debt is treated as follows. The allocation of an amount of debt discharge income to a partner results in that partner's basis in the partnership being increased by such amount (sec. 705). The reduction in a partner's share of partnership liabilities caused by the debt discharge also results in a deemed distribution (under sec. 752) which in turn results in a reduction (under sec. 733) of the partner's basis in his partnership interest. This section 733 basis reduction is separate from any reduction in basis of the partner's interest under the provision, i.e., the basis reduction that occurs as a result of treating the partnership interest as depreciable real property to the extent of the partner's proportionate interest in the depreciable real property held by the partnership (provided the partnership makes a corresponding reduction in the basis of depreciable partnership real property with respect to that partner).

Elective exclusion of COD income in this situation is analogous to exclusion of COD income resulting from reduction of purchase money indebtedness under §108(e). Since the latter provision has been around for some time, I have experienced its operation in practice. The mechanics are as follows.

The partnership recognizes COD income and allocates such income among the partners in accordance with the partnership agreement. The offsetting entry is, of course, debt. The partners presumably elect to exclude the income and make corresponding reductions in the basis of their partnership interests. To the extent the partners so elect, the partnership decreases the basis in its depreciable real estate. The offset is to partners' capital.Attached is a computation using an extremely simplified fact pattern simply to illustrate that all this does really work.

The IRS recently issued Temporary Regulations (Reg. 1.108(c)-1T) and Announcement 94-11 to deal with the mechanics of the election process. Each partner must individually elect to exclude the COD income. The election is made on Form 982 which has recently been amended to include a check-off box to cover this circumstance. Form 982 must be included with each electing partner's tax return for the year in which the discharge occurs.